STEP response to HMRC Consultation on Vulnerable Beneficiary Trusts (publication date 17 August 2012)

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1 STEP response to HMRC Consultation on Vulnerable Beneficiary Trusts (publication date 17 August 2012) The Society of Trust and Estate Practitioners (STEP) is the worldwide professional body for practitioners in the fields of trusts and estates, executorship and related issues. STEP members help families secure their financial future and protect the interests of vulnerable relatives. With over 6,000 members in the UK (and over 17,500 members around the world), STEP promotes the highest professional standards through education and training leading to widely respected professional qualifications. STEP welcomes the opportunity to comment upon this HMRC Consultation on Vulnerable Beneficiary Trusts. This response has been drafted by STEP s Mental Capacity Special Interest Group (which brings together STEP members with a particular interest in mental capacity issues)in association with STEP s UK Technical Committee. Executive summary The starting point in considering any change to the present regime is that the overriding objective should be to ensure that disabled beneficiaries should not be taxed any more adversely than if they owned the property themselves. All reform to the tax system should be tested against this premise. The present system fails in this objective in a number of respects both during the lifetime of the beneficiary and on death. The anomalies which tax disabled trusts more severely than an individual therefore need to be removed. In particular we refer to the penal double tax charge to both CGT and IHT on the death of a disabled beneficiary where assets are held in most types of disabled trust and the very complex and anomalous rules that apply if a vulnerable beneficiary election is made for income tax and capital gains tax purposes. We are disappointed that the consultation document does not make any attempt to discuss these issues which are relevant if one of the purposes of the Consultation is to seek to make the taxation of disabled trusts fairer. A second purpose of the Consultation should be to devise and introduce a simpler tax system for disabled beneficiary trusts that is fit for purpose and avoids conflicting rules for different reliefs The current vulnerable beneficiaries tax regime is particularly complex: tax pools, the differentiation between settlor and non-settlor interested trusts and the conditions for and method of obtaining relief mean that the regime is rarely used in practice. As HMRC noted, very few elections have been made by disabled trusts.

2 In summary the taxation of disabled beneficiaries and their trusts needs to be wholly rethought. We would suggest that this should be dealt with by the Office of Tax Simplification. Some policy changes will be needed to improve the system but we suggest that these changes will be yield neutral. At present the complexity of the tax system for disabled beneficiary trusts puts people off using these trusts at all. As we explain in more detail below: 1. The Mental Capacity Act 2005 ( MCA ) test for lack of mental capacity to make a decision is very useful but this may not fit an ongoing trust as a result of its decision specific nature. 2. A single global definition covering both mentally and physically disabled beneficiaries appears too hard to draft but a threshold based on qualification using one of a list of existing statutory definitions may be a possible solution- but could be too wide. 3. A combination of the Personal Independence Payment (PIP)/Attendance Allowance ( AA ) and MCA tests might be the best practical definitional solution- but it is hard to be conclusive until the final PIP qualification is agreed (so we can be sure how it differs from Disability Living Allowance ( DLA )). 4. Generally we are concerned that the definition of disabled beneficiary is too narrow. 5. The application of capital conditions should be sufficiently flexible to allow distributions of capital to be made in limited circumstances which are not for the direct benefit of the disabled person. 6. IHT reliefs should be available even if the disabled beneficiary was not disabled at the time of the original settlement of the funds. 7. CGT uplift should be available on the death of the disabled beneficiary whatever the type of trust. 8. It should be possible to switch between different types of trust and preserve IHT reliefs. 9. Whilst we applaud the harmonisation of the qualification and operation conditions between the taxes concerned which should aid understanding of this kind of trust, we are disappointed that the most restrictive conditions have been selected which may well discourage the use of these specially designed trusts. 10. The Finance Act 2005 ( FA 2005 ) vulnerable beneficiaries regime reporting and relief system would benefit from radical simplification.

3 Question 1: Do respondents consider that vulnerable people have distinguishing characteristics outside of the two groups outlined at paragraph 3.3 (actually 3.4). If so, what are they and why? The two groups outlined at paragraph 3.4 are defined using language indicating that their key characteristic is the need to protect them from their own behaviour or lack of ability or from other people. This is only one aspect of the modern view of the characteristics which make people vulnerable - and is somewhat out of date in our opinion. As far as mental incapacity is concerned the language of the MCA and the consultations which preceded it- in particular section 1 of the Act which sets out its basic principles -emphasises that the vulnerable should also be empowered and enabled to develop their potential with appropriate support. Section 1-(6), for example, states that any act done or decision made under the Act must be preceded by regard having been had to whether the purpose for which it is needed can be as effectively achieved in a way that is less restrictive of the incapable person s freedom of action. Chapter 3 of the MCA Code of Practice includes a number of suggestions for steps that can be taken to help vulnerable people make their own decisions and support them in doing so. Section 1-(3) MCA further provides that a person is not to be treated as unable to make a decision unless all practical steps to help him to do so have been taken without success. The missing distinguishing characteristic of the vulnerable person is not just that they need protection from their lack of ability but that they need support to realise as much potential as they have and the urge to protect must be tempered by recognition of this fact which should be reflected in the definitional threshold of who is vulnerable. Question 2: Do respondents have suggestions for defining a vulnerable person for tax purposes other than by reference to orphaned minors and those with a severe physical or mental disability? (Responses may include approaches and concepts found elsewhere that could be included into the tax code either in combination or in isolation). It appears that there are probably three options for changing the definition of a vulnerable person. Broadly the same as now - a PIP instead of DLA related test plus mental disability qualification test (probably using the definition in the MCA rather than that in the Mental Health Act ( MHA )). A qualification based on compliance with any one of a list of definitions from existing statutes. A new combined definition incorporating the best elements of all the existing definitions. Taking on board the dual aim of protection and empowerment on the one hand and the need for certainty in the wording of tax legislation on the other, it is recognised that it is probably impractical to consider a combined definition of vulnerable person lifting language from the multiplicity of existing statutes which seek to define the vulnerable for a number of purposes. Taking a simpler view, a combined definition which seeks to incorporate a DLA/PIP like qualification on the one hand and a MHA/MCA definition on the other is also probably not going to be successfully drafted.

4 That said, a number of the other existing definitions are attractive if applied to a disabled trust. The definitions, for example, in the Safeguarding Vulnerable Groups Act 2006, Section 59 and Police Act 1997 (Enhanced Criminal Record Certificates) (Protection of Vulnerable Adults) Regulations 2002 are particularly interesting to consider. However, some of the other existing definitions (for example Section 34 FA 2005) appear not to be a good fit as they do not reflect in any way the potential for change in a vulnerable person s disability and contain requirements which effectively need to be complied with life-long. A qualification based on compliance with any one of a list of definitions from existing statutes might lead to too wide a definition of disabled person. Option 1 above therefore may well be the best way forward. Nevertheless the existing system does need to be reviewed. The existing eligibility criteria related to Attendance Allowance appears to admit a class of beneficiaries with a lower level of disability than those who fulfil the DLA middle or higher care component qualification. There seems to be no mention of the Attendance Allowance eligibility in the consultation paper. Question 3: In relation to those suggestions, what practical issues do respondents envisage applying them in the context of a self-assessed tax how could they be overcome? 1. Time of qualification At present the IHT qualification rule criteria relies on a single point in time when the settlement is made (or on the advent of incapacity in relation to self-settled trusts). This differs from income tax and CGT where an annual qualification regime currently applies. This is a dichotomy which must sensibly be addressed between the taxes. The qualification timing is particularly relevant in the following situations: (a) Where there is a resettlement for the benefit of a disabled beneficiary who was not alive or was alive but not disabled at the time the original trust was made. (b) Where the person was not disabled at the date of the original trust but the latter is then converted into a disabled trust for that person s benefit. This occurs with will trusts where the family want to use the funds to help a disabled beneficiary who may not have been alive or disabled on the original death. We recommend that a trust can qualify for the disabled trust IHT reliefs at any time if from that date it satisfies the criteria for disabled trusts (whether discretionary or otherwise) and the beneficiary does not need to be disabled when the funds were first settled. The IHT restrictions necessary to qualify as a disabled beneficiary trust are such that during the disabled beneficiary s lifetime the funds cannot be used for any other purpose.

5 2. Proof of qualification One option might be an annual health check (provided free by the NHS?) to confirm ongoing eligibility or perhaps a periodic renewal (along the lines of driving licences for those aged over 70).We do however have a concern that the cost of a medical certificate of disability could be a particular burden to the smaller personal injury trust, especially if GP s charge for the privilege. Additionally, the experience of mental capacity specialists of obtaining certificates to confirm testamentary capacity indicates that many GP s are reluctant to give such a certificate and it would be anticipated that a similar reluctance would exist if certificates were required for qualification for a disabled trust - particularly on a mental incapacity ground. Question 4: Do respondents agree that including recipients of the enhanced rate daily living component of PIP within the vulnerable person definition would achieve certainty in the same way as the existing reference to DLA does? We do but have an additional concern about transition. Section 7 of the consultation (although referring to paragraph 2.4 indicating that the changes resulting from the consultation will be made to coincide with the introduction of PIP) does not make it clear what will happen to those whose qualification under the existing vulnerable beneficiary regime in FA2005 comes to an end when they cease to qualify for DLA but do not qualify for PIP. Is it proposed that existing beneficiaries in this position will no longer qualify for the FA 2005 regime, or will any changes only apply to new trusts created after the introduction of PIP or any amendment to an existing trust, again after that date? Question 5: Would including recipients of the enhanced rate daily living component of PIP within the vulnerable person definition be an effective category to support the targeting of the tax treatment for those beneficiaries with a severe physical or mental disability? It is difficult to answer this question. As made clear in paragraph 2.15 the Department for Work and Pensions is still in process of consulting on the following proposed assessment activities for the mobility and daily living components of PIP, both at the standard and enhanced rates. Paragraph 2.16 makes it clear that only once the details of PIP are finalised will it be clear whether the daily living component will offer a sensible alternative to the care component of DLA. This question is therefore premature as it will need to be clear what the differential between the existing DLA qualification criteria and the new PIP qualification criteria will be. It is clear from publicity about the change from DLA to PIP that the numbers of claimants who will qualify for PIP will be significantly lower than those who currently qualify for DLA. Paragraph 8.6 states figures indicating a differential of only 100,000 claimants, however other figures reported in the press indicate that the current number of DLA claimants at the higher or middle rate is 1.8 million meaning that approximately one third of current DLA claimants will not qualify for PIP. The differential between the number of potential claimants is obviously key to informing the utility of the PIP definition as part of the eligibility criteria for disabled trusts.

6 Question 6: What are respondent s views on whether the proposal for PIP might lead to a suitable test, or part of a test, for assessing whether someone should be able to benefit from access to the tax treatment for vulnerable persons trusts? (Responses should have regard to the characteristics that distinguish a vulnerable person). We have doubts in relation to this. The PIP test, although encompassing some financial and strategic decisions, principally concentrates on the activities of daily living i.e. preparing food and drink, bathing, dressing and undressing, communicating etc. The concept of a vulnerable beneficiary for the purposes of a discussion of disabled trusts encompasses a wider set of strategic questions arising from the purpose of the trust; to both protect funds for the benefit of a disabled person but also, as mentioned above, to enable that person to participate as far as possible in decision making concerning his life and finances. This is a broader canvass than that painted by PIP alone. Although there is obviously a significant overlap between the needs of a physically vulnerable person and the needs of a person who is mentally disabled, there are separate and distinct aspects when the broader picture is looked at and a qualification under PIP alone is probably not sufficiently encompassing. Question 7: Is the existing mental incapacity test suitably targeted? If not, why not? The existing test of lack of capacity in Sections 2 and 3 MCA is considerably more suitable for assessing capacity to make an individual decision rather than to set up or participate in a trust structure which will be a decision making body as part of a broad plan for a vulnerable person. Section 2 MCA makes it clear that lacking capacity is assessed in relation to a matter if at a material time a person is unable to make a decision for himself in relation to a matter because of an impairment of or a disturbance in the functioning of, the mind or brain. The Mental Health Act 1983 definition and ethos, particularly as applied to, for example, Enduring Powers of Attorney ( EPAs ), is much more in tune with the concept of an ongoing structure for an incapable person. Under the Enduring Powers of Attorney Act 1985, an EPA was registered if the donor was, or was becoming incapable, by reason of mental disorder, of managing and administering their property and affairs. At that point, the EPA was registered and the attorneys took over, effectively excluding the donor from the majority of decisions which were then taken by the attorneys. The MCA replaced this concept of one side or the other of a given line with the concept of a partnership between the decision maker and the vulnerable person which allowed for a flexible relationship permitting the incapable person to make such decisions as they could at the relevant time. The MCA individual decision approach does not seem to sit comfortably with the disabled trust tax structure. Question 8: What alternative approach would respondents propose and why? (Responses need not be limited to suggestions that make use of MCA 2005). We are generally concerned that the definition of a disabled beneficiary is too narrow and particularly the capacity over financial affairs is too narrow. However it is recognised by the flexible approach taken by the MCA that it is possible for somebody to have an IQ below which a beneficiary could be classed as vulnerable, but this might not be an appropriate measure. For

7 example, some Downs Syndrome beneficiaries might not come within the definition but their parents would not wish to leave them much direct access to funds. One suggestion for an alternative approach might be to use the combination of Sections 2 and 3 MCA to incorporate the definition of people who lack capacity and the inability to make a decision but removing at the material time which appears in Section 2(1) MCA and possibly substituting reference to a specified period or perhaps a time from when the trust was made. We feel concerned about the suggestion of identifying those with a long term lack of capacity. This may be very clear in some cases but may not be in others. For example, schizophrenia commonly develops amongst young men in their late teens however both the maturity process and medication may lead to a significant improvement in their condition and ability to manage assets. The timescale for such improvement varies significantly from individual to individual. Question 9: What practical issues do respondents experience when applying the current mental incapacity test, or envisage with any alternative; and how can they be overcome. See responses to Questions 7 and 8 above. Question 10: Do respondents see any reason why the application of capital conditions should not require the vulnerable beneficiary to benefit from every application of the capital during the lifetime (or other relevant period) of the vulnerable beneficiary (with consequent changes to the provisions disregarding trustee s general statutory powers of advancement)? Generally, we are disappointed that the consultation paper has suggested aligning the conditions for capital and income to the most restrictive rather than the best test. It is in our opinion sometimes not always clear whether the payment of capital is for the benefit of a disabled beneficiary or another individual- for example to pay for their carer to have a much needed break. An alternative might be to allow the current 50% test to stand or at least to increase the flexibility such that some distributions can be made to help carers and potentially others without having to consider whether this is for the direct benefit of the disabled beneficiary. Other alternatives to the aligning of the capital distributions as suggested might include the following: A percentage allowance. This might not, in reality, be practical because in circumstances where the vulnerable person does not receive benefit, securing that distributions remain within the percentage in a given year would require sufficiently large applications which do benefit the vulnerable person to be made which may be undesirable to be made to them at that time. A fixed exemption. This might be based on the IHTA Section 19 annual exemption of 3,000 with perhaps the ability to carry forward one year. This would be logical insofar as the taxation of vulnerable beneficiary trusts should be analogous to property being held directly by the vulnerable person.

8 We suggest that there is no need for a formal definition of the word benefit. It is a familiar trust law concept and to define it would only cause confusion given the extensive case law on the point. We would also suggest that the IHT changes should apply to new settlements only. We also remain significantly concerned that if it is the aim of tax policy in this area that the provisions of a disabled trust should not put a disabled person in any better tax position than a non-disabled individual whilst allowing them to have the benefit of the protective structure of a trust, the lack of an uplift for CGT on the death of the disabled beneficiary, as a charge to IHT also arises, is unfair. We are aware that Section 89B trusts with an actual interest in possession do benefit from an uplift but these trusts are less commonly used. The lack of uplift also has the unfortunate effect of making these trusts, which were specifically created for the benefit of disabled beneficiaries, less popular and consequently less used. We have already pointed out the anomalies arising from the fact that the disabled beneficiary has to be alive and disabled at the date of the original settlement of funds. Finally, switching between types of trusts generally causes difficulties. There are cases where a trust is set up which is intended to meet Section 89 requirements but where the trustees can only accumulate income for 21 years, after which it gets paid to the disabled person. In the view of HMRC, the conditions of Section 89 are not met because at the end of the accumulation period an interest in possession arises. The trust therefore becomes relevant property but will become disabled when the interest in possession vests. This problem is, of course, now avoided by the unlimited accumulation period following the coming into force of the Perpetuities and Accumulations Act 2009 on 6 April This does not, however, help in relation to trusts set up before that date. It ought to be possible to switch between the discretionary and interest in possession trust regimes as long as the basic restrictions on paying income to someone other than the disabled beneficiary are met. Question 11: Do respondents see any reason why the application of income conditions should not be harmonised so that trustees are prevented for paying income to non-vulnerable beneficiaries during the lifetime (or relevant period) of the vulnerable beneficiary? We have various points in relation to this suggestion. Generally, the vulnerable beneficiary election and regime is unnecessarily complex. We understand that less than a thousand vulnerable persons elections are made in any one year and this is unsurprising considering the complexity of the FA2005 rules. We have the following suggestions: 1. Broadening the vulnerable beneficiary election from its limited use which usually limits the availability to a life interest trust where income is already paid to the life tenant and so would be disclosed on their personal tax return. 2. The tax pool concept should be abolished for disabled trusts. The income and gains should be taxed on the disabled beneficiary directly as if he had received the income or gains -like the old settlor interested trust tax regime. This would avoid the trustees having to do

9 complex tax returns and claims as well as the beneficiary. One tax return for the beneficiary showing all trust income and gains could be completed. We have had comments that, under the present system, some practitioners who are regularly creating settlor interested personal injury trusts are creating bare trusts simply to avoid the vulnerable beneficiary regime complexity whereas a disabled trust falling within one of the IHT definitions might have many advantages. 3. It should be possible to combine the trust drafting in a single provision which would cover both the deemed interest in possession under Section 89 and the actually interest in possession under Section 89B. In both cases, we would argue that the CGT uplift should be available on the death of the disabled beneficiary. 4. If the general principle which we have set out that the trust fund should be considered in tax liability and compliance terms as if it were held directly by the vulnerable beneficiary - holds good, the application of that principle to those on means tested welfare benefits should be considered. Is it right that property within a vulnerable persons trust should be disregarded and not compromise entitlement to welfare benefits? This question, however, should not apply where the funds settled are personal injury damages. Question 12: Are any transitional provisions required? If so, what transitional arrangements would respondents suggest? See above for our comments relating to the change from PIP to DLA and the changes relating to Section 89. Question 13: What adverse impacts on the equality groups do respondents expect? How do respondents suggest any such impacts be mitigated? Question 14: Do respondents know, or can they estimate, the likely number or proportion of vulnerable beneficiary trusts for severely disabled beneficiaries that currently qualify on the basis of the DLA criteria as opposed to the other two criteria listed at paragraph 2.9? We are surprised by paragraph 8.3 setting out the result of the Revenue s research. It appears that the outcome of the research was contrary to that received by those who drafted the FA2006 changes in relation to the inheritance taxation of trusts when it was made clear that tax planning and avoidance was the main motivation for the creation of a private trust. STEP Mental Capacity Special Interest Group and STEP UK Technical Committee 6 November 2012