INHERITANCE TAX PLANNING AND TRUSTS

Transcription

1 INHERITANCE TAX PLANNING AND TRUSTS LIFETIME TRUSTS Introduction The Finance Act 2006 introduced significant changes to the Inheritance Tax (IHT) treatment of trusts with effect from 22 March The purpose of this paper is to investigate estate planning opportunities which are still available both (a) during the lifetime of an individual and (b) on death. It is necessary to explore the IHT treatment of trusts prior to the Finance Act 2006 in order to understand their current tax treatment. HMRC have produced a Consultation Document, Inheritance Tax: Simplifying Charges on Trusts the next stage ( the Consultation Document ) proposing changes to the taxation of relevant settlements. These changes are examined, in particular as they affect the use of pilot trusts. Overview: position prior to FA 2006 Prior to the Finance Act 2006 there was a critical distinction drawn for IHT purposes between: (a) settlements with a qualifying interest in possession ( IIP ); and (b) settlements without a qualifying IIP which included: a. relevant property trusts, such as discretionary trusts, which were subject to 10-year anniversary and exit charges; and b. privileged trusts such as accumulation and maintenance ( A&M ) trusts and a disabled person s trust, which were not subject to the relevant property charging regime, but which attracted special tax treatment. IIP trusts: pre-2006 A person, beneficially entitled to an IIP in settled property, was treated as beneficially entitled to the property in which the interest subsisted (IHTA 1984, s. 49(1)). An IIP was a qualifying IIP, outside the relevant property regime, if an individual, or in some cases a company, was entitled to the present right of present enjoyment (Pearson v IRC [1981] AC 753), i.e. the immediate right: a. to the net income of the settlement as it arises; or b. to enjoy or occupy any trust property (whether or not it produces income); c. without the trustees having to make any further decision to confer such a right. 1

2 A trust to pay income to X for life is, therefore, a classic example of an IIP trust. X has an IIP so long as X is entitled to the trust income, as it arises, even if his interest is revocable, or defeasible by the trustees exercise of overriding powers of appointment or advancement. IHT treatment of IIP The fiction was adopted that the settled property was the absolute property of an individual beneficiary presently entitled to its income or enjoyment. This fiction had certain IHT consequences: (1) A transfer by S to a settlement in which another individual (X), other than S s spouse, had an IIP was a PET as a gift to another individual (IHTA 1984, s. 3A(1)(c)). (2) A transfer by S to a settlement in which S had an IIP did not give rise to a transfer of value, as the transfer was deemed to be by S to S. (3) A transfer by S to a settlement in which S s spouse had an IIP was an exempt transfer between spouses (IHTA 1984, s. 18). (4) On the death of the IIP beneficiary, the settled property in which the IIP subsisted was aggregated with his free estate, of which he was deemed to have disposed on death, and taxed at 40%, subject to the nil rate band and any exemptions (IHTA 1984, s. 4, 5). (5) The termination of an IIP: a. upon trust for another individual beneficiary (other than a spouse) absolutely or on IIP trusts, was a PET; b. in favour of a spouse absolutely or on IIP trusts, was exempt; and c. on continuing non-iip trusts was immediately chargeable. Relevant property trusts All trusts, in which a qualifying IIP did not subsist, other than certain privileged trusts, were, prior to 22 March 2006, subject to the relevant property regime. Relevant property trusts were typically discretionary trusts (in which no beneficiary had any entitlement to income). They are, and were, subject to their own charging regime whereby the trust, rather than any beneficiary, was the chargeable entity. No charge arose on the death of any beneficiary. Relevant property trusts were (and still are) subject to the following charges: a. an exit charge, at a rate of between 0% and 5.85%, where the settled property ceases to be relevant property, charged on the diminution in the value of the relevant property; and 2

3 b. a 10-year anniversary charge, at a rate between 0% and 6% on the value of the relevant property at the anniversary, on each 10 th anniversary of the commencement of the settlement. Lifetime transfers: pre-fa 2006 A lifetime gift into a settlement was either: a. an immediately chargeable transfer ( ICT ); or b. a potentially exempt transfer ( PET ). Lifetime transfers to the following trusts were PETs: a. an IIP trust, such as a life interest trust; b. an A & M trust; or c. a disabled person s trust. PET In the case of a transfer by a settlor into a trust by way of a PET: a. The PET is exempt, and there is no charge to IHT, at the date of transfer, or on the subsequent death of the settlor, unless the settlor dies within 7 years of the transfer (in which event the transfer becomes chargeable). b. If the settlor dies within 7 years of the transfer, IHT is charged on the value of the transfer at the date of transfer, but at the full death rate prevailing at the date of death (currently 40% above the nil rate band taking into account any chargeable transfers made within the period of 7 years prior to the PET). However, taper relief applies to reduce the rate of IHT on the failed PET if the settlor survives between 3 and 7 years. Unless the settlor survives for 7 years, the value of the transfer forms part of the transferor s cumulative total on death. c. Any gain on the disposal of assets into the trust cannot be held over, unless the assets transferred are business assets within TCGA 1992, s ICT In the case of a transfer by a settlor by way of an immediately chargeable transfer ( ICT ): 3

4 a. On making such a transfer, IHT is immediately chargeable at half the death rate at 20% on the value transferred in excess of the nil rate band, taking into account the value of any chargeable transfers made within 7 years prior to the transfer. b. If the IHT is paid by the settlor, this increases the value transferred. The value of the transfer is grossed up (100/80 x the value transferred over the nil rate band). c. In the event that the settlor dies within 7 years of the transfer into the trust, additional IHT is chargeable, as the IHT payable on the transfer is recalculated at the rate in force on the date of death (currently 40% in excess of the nil rate band), credit being given for any tax previously paid. Taper relief applies to reduce the death rate to a minimum of 20% in respect of transfers made between 3 and 7 years before death. In practice, a liability will only arise if the value transferred into the trust exceeds the nil rate band at the date of death. Unless the settlor survives for 7 years, the value of the transfer will form part of the settlor s cumulative total on death. FA 2006 changes: transfers to lifetime trusts The Finance Act 2006 introduced significant changes to the taxation of lifetime trusts with effect from 22 March Principally, it is no longer possible to create a lifetime trust, in which there will be a qualifying IIP, except in the case of a trust in which a person has a disabled person s interest within the meaning of IHTA 1984, s. 89B. An individual, and in a limited class of cases a company (IHTA 1984, s. 59(1)(b), (2)), who became beneficially entitled to an IIP in a lifetime trust (or one created on death) prior to 22 March 2006 continues to be treated as being entitled to the property in which the IIP subsists (IHTA 1984, s. 49(1), (1B)). The transfer to such a trust, prior to 22 March 2006, was a PET, and the trust will continue to be taxed as if the IIP beneficiary is entitled to the settled property in which the IIP subsists. However, a transfer by a settlor, on or after 22 March 2006, to a lifetime trust cannot be a PET, but will be an ICT, in respect of which IHT is immediately payable at 20% over and above the nil rate band, unless: a. The transfer is to a trust in which there is a disabled person s interest (a PET); or b. The transfer is to a bare trust for an individual, including a child under the age of 18 (which will be a PET). c. The transfer is exempt (as in the case of a transfer to a charitable trust, or to an employee trust, or where the normal expenditure out of income exemption in IHTA 4

5 1984, s. 21 applies); or d. The transfer does not give rise to a transfer of value, e.g. where there is a settlement of excluded property (such as the settlement of non-uk property by a non-uk domiciled settlor) or where the settlement is made without any intention to confer a gratuitous benefit (IHTA 1984, s. 10) as might be the case with a settlement made on divorce; or Further consequences are: a. A lifetime transfer by S to trustees, upon trust to pay the income to S, is a chargeable transfer. Previously, there was no transfer of value as S was deemed to be making a transfer to himself. b. A lifetime transfer by S to trustees, upon trust to pay the income to S s spouse, is also a chargeable transfer, unless the spouse has a disabled person s interest (in which case it will be a PET). The transfer is no longer exempt as a transfer between spouses. However, the transfer could be exempt if it is a disposition for the maintenance of the family (IHTA 1984, s. 11). c. A&M trusts are now relevant property settlements. In consequence, a transfer to an A&M trust is no longer a PET, but an ICT. Taxation of lifetime trusts A lifetime trust, in which a beneficiary became entitled to an IIP on or after 22 March 2006, cannot qualify as an IIP settlement in which the IIP beneficiary is treated as beneficially entitled to the settled property itself. The only exception is where the beneficiary has a disabled person s interest within the meaning of IHTA 1984, s. 89B. In consequence: a. Most non-iip lifetime trusts are now subject to the relevant property regime, subject to 10- year and exit charges, with the exception of: i. trusts in which there is a disabled person s interest (where the disabled person is deemed to be entitled to the settled property itself); and ii. certain favoured trusts such as charitable trusts and excluded property settlements (which are exempt from IHT) and employee trusts (which are subject to a special charging regime). (2) On the death of a beneficiary with a non-qualifying IIP, the trust property in which the IIP subsists will not be aggregated with the beneficiary s free estate. The corollary is that the 5

6 GGT-free uplift on death, in respect of trust assets in which such a non-qualifying IIP subsists, does not apply. (3) The termination of an IIP in a lifetime trust in favour of an individual, absolutely or on IIP trusts, will not be a PET. Tax disincentives of creating new lifetime trusts There are significant tax disincentives in making a transfer of non-excluded property upon lifetime trusts (unless the transfer is exempt or does not give rise to a transfer of value) on or after 22 March 2006: (1) The transfer to the trust gives rise to ICT, with an immediate charge at 20% above the settlor s unused nil rate band, even if the settlor survives for 7 years (see ICT above). (2) Although a gain on the disposal of assets into the trust can be held over, being a disposal which is a chargeable transfer for IHT purposes (TCGA 1992, s. 260(2)(a)) such relief is not available if the settlement is settlor-interested. This will be the case if the settlor, spouse or civil partner of the settlor, or a dependent child has an interest under the settlement (TCGA 1992, ss. 169B-169G). A dependent child means a child who is under the age of 18, unmarried, and does not have a civil partner (s. 169F(4A)). (3) The trust will be subject to 10-year anniversary and exit charges. (4) On the termination of a post-21 March 2006 IIP for another individual absolutely, there will not be a PET, but there will be an exit charge. (5) The tax-free uplift on death, for assets subject to CGT, will not apply to the trust assets, whereas it would have applied to those assets had they been retained as part of the settlor s free estate. Outright gifts In many cases, it would be more tax-effective for a potential settlor to make an outright gift to another individual or individuals, or to a bare trust for an individual, including a minor: (1) The gift will qualify as a PET. (2) There will be no 10-year anniversary and exit charges. (3) If there is a gain, it cannot be held over. But that is also the case where there is a disposal to a settlor-interested settlement (as widely defined). It may in any event be possible to gift assets which are not pregnant with gain, or to give cash. 6

7 (4) The donee (unless a minor) can make a PET of the gifted property in due course in the hope of surviving for 7 years. (5) The CGT-free uplift, on the death of the donee, will apply to assets retained by the donee at death. Consequences for use of lifetime trusts In many cases, a potential settlor will not want to make an outright gift to an individual, or to a bare trust for a minor. The settlor may want the flexibility of a trust under which discretionary powers are given to the trustees; or to limit the interest of a beneficiary, e.g. to income; or to postpone entitlement beyond the age of 18. However, the biggest disincentive to the use of a lifetime trust is that the settlement of sums in excess of the nil rate band (currently 325,000) is subject to an immediate charge at 20% on the value transferred above the nil rate band. Therefore, most new lifetime settlements will: a. be of a value limited to the settlor s nil rate band; b. comprise property attracting business or agricultural property relief; c. be of excluded property ; or d. fall within the normal expenditure out of income exemption. Excluded property Property held in a settlement is excluded property if the settlor was domiciled outside the U.K. when he made the settlement, and the settled property is not situated in the U.K. (IHTA 1984, s. 48(3)(a)). Trusts of foreign property settled by a non-u.k. domiciled settlor have certain advantages provided that the settlement continues to hold foreign property: (1) The transfer by a non-u.k. domiciled settlor of foreign property into a trust during his lifetime will not give rise to a transfer of value for IHT purposes (IHTA 1984, s. 3(2)). (2) If the foreign property is settled by the will of a non-u.k. domiciled person, there will be no IHT charge on the death of the testator in respect of that foreign property since a person s estate immediately before death does not include excluded property (IHTA 1984, s. 5(1)). (3) The settlor can retain an interest in a lifetime settlement until death. Even though the settled property will be property subject to a reservation of benefit on death, such property will be excluded property outside the charge to IHT. If, before the death of the settlor, the foreign property ceases to be subject to a reservation of benefit, the settlor will be deemed not to have made a transfer of value (IHTA 1984, s. 3(2)). 7

8 (4) The trust will not be subject to exit and 10-year charges (IHTA 1984, s. 58(1)(f)). A distribution to a U.K. beneficiary will not, therefore, be subject to an exit charge. It is outside the scope of this paper to explore in any detail the use of settlements of foreign property by non-uk domiciled settlors. Form of lifetime trust For IHT purposes, the form of a lifetime trust does not much matter, since all trusts, other than disabled person s trusts, will be subject to the relevant property regime. Normally, a full discretionary trust is used for maximum flexibility. However, an IIP trust, such as a life interest trust, may have some attractions, even if such a trust is within the relevant property regime for IHT purposes: (1) The settlor may want to ensure that, say, a spouse, is entitled to income for life, and/or that other beneficiaries, such as the settlor s children, are entitled to capital on the death of the life tenant. (2) A higher special rate of income tax (currently 42.5% on dividend income, and 50% on other income) is payable by the trustees of a discretionary or A&M trust (ITA 2007, ss ). In the case of an IIP trust, the income can be mandated to the beneficiary, who will pay income tax at his or her rates. The trustees will not need to submit a tax return. (3) It is possible, if desired, to introduce great flexibility in the case of a life interest trust, by giving the trustees overriding powers of appointment and extended powers of advancement. Flexible IIP trust for grandchildren A settlement could, therefore, be created whereby: (a) The income of the trust fund is payable to the settlor s first grandchild for life. (b) If another grandchild is born, the trustees can appoint one-half of the trust fund to the second grandchild. This would not give rise to a transfer of value, as the settlement would still be wholly within the relevant property regime. (c) On the death of a grandchild with an IIP, no charge would arise so long as that grandchild s interest remained settled. TAX PLANNING USING LIFETIME TRUSTS Nil rate band trusts every 7 years John and Mary are aged 58 and 57 respectively. 8

9 They have not made any chargeable transfers within the previous 7 years. They wish to settle the maximum amount possible on trusts for their adult children, and grandchildren, without giving rise to any IHT liability during their lifetimes. John and Mary should both settle a sum equal to their respective nil rate bands (currently 325,000) on trust for their children and grandchildren. This can be repeated every 7 years. In consequence: (1) There will be no IHT charge on the transfers into the settlement since the transfers will be within the nil rate band of the settlor. (2) If the settlor survives for 7 years from the last settlement made by him/her, the value transferred into that settlement will not form part of his/her cumulative total on death. (3) Any capital gain can be held over as the settlement will not be settlor-interested. (4) John and Mary can add cash or assets equal to their annual exemptions ( 3,000) every year. John and Mary could, therefore, settle 650,000 (plus any available annual exemptions) every 7 years. At present values, this would remove about 1.95M. from their combined estates if they both survive to 80. They can make gifts to the same trust, as that trust will be treated as two separate trusts for IHT purposes (IHTA 1984, s. 44(2)). Distribution before 10 th anniversary It may be sensible to appoint property out of a relevant property settlement shortly before the first 10-year anniversary, if the value of the settled property has increased substantially in value. In 2013/14 John settled 325,000 on nil rate band trusts for his adult children and minor grandchildren (see Nil rate band trusts every 7 years above). The value of the trust fund has doubled to 510,000 shortly before, and on, the first 10-year anniversary in 2023/24, when the nil rate band is 400,000. If the trust fund were appointed to John s children absolutely in the quarter immediately before the 10 th anniversary, there would then be: a. an exit charge, under IHTA 1984, s. 65 on the reduction in the value of the relevant property as a result of the distribution ( 510,000); b. at a rate, calculated in accordance with IHTA 1984, s. 68, of 5.85% on the amount (if any) by which the value of the relevant property on commencement ( 325,000) exceeds the available nil rate band on exit ( 400,000). 9

10 The available nil rate band on exit ( 400,000) would be greater than the value of the relevant property on commencement ( 325,000) with the result that the appointment would be at a nil rate. A nil rate would apply even though the value of the relevant property at the date of the appointment ( 510,000) is more than the nil rate band at that date. Thus, the rate of IHT on an exit from a relevant property trust is fixed for 10 years by reference to the value, immediately after the settlement (and any related settlement) commenced, of the property then comprised the settlement and any related settlement (IHTA 1984, s. 68(5)). Exit charges on settlements equal to the nil rate band will, therefore, be at a nil rate (assuming that the settlor had not made any chargeable transfers within the 7 years prior to the commencement of the settlement, and that there have been no additions to the settlement). If the trust fund had not been wound up before the first 10-year anniversary, but retained, there would have been a charge on the 10 th anniversary by reference to the value of the relevant property on the 10 th anniversary. The value of the relevant property on the 10 th anniversary ( 510,000) would have been greater than the available nil rate band ( 400,000). There would, therefore, have been a charge on the 10 th anniversary. Sale at an undervalue Fred wishes to settle shares, worth 1M., on discretionary trusts. Fred does not want to pay IHT on the transfer into the trust. His current nil rate band is 325,000. The shares are worth 1.5M on the first 10-year anniversary. Fred should consider a sale of the shares at an undervalue: (1) Fred would sell the shares to the trustees for 675,000, to be left outstanding as a freeof-interest loan repayable on demand. (2) Fred would be making a transfer of value of 325,000 (within his nil rate band). The loan of 675,000, being repayable on demand, should not give rise to any transfer of value. (3) The loss of interest should not give rise to an IHT liability, having regard to Fred s annual exemption of 3,000 and/or the normal expenditure out of income exemption. (4) Any gain on the assets transferred into the trust could be held over (TCGA 1992, s. 260). (5) On the 10 th year anniversary the value of the trust fund will be 1.5M. less 675,000 ( 825,000) on which there is likely to be some (small) charge. However, the growth in value ( 500,000) will not form part of Fred s estate on death. 10

11 Note: If land is sold to the trustees, SDLT would be payable on the consideration. It is also important, for income tax reasons, that the loan is not repaid. Assets pregnant with gain Jane wishes to give a painting, within the value of her nil rate band, to her adult daughter, Holly. The painting has risen substantially in value since it was acquired, so that CGT is a concern. The gain cannot be held over on a PET by Jane to Holly. Instead: (1) Jane could give the painting to a discretionary trust for a class of beneficiaries, including Holly. (2) As the value of the painting is within Jane s nil rate band, there is no charge on the transfer to the trust. However, the gain can be held over as the disposal into the trust is a chargeable transfer for IHT purposes (TCGA 1992, s. 260(2)(a)). (3) The trustees could subsequently appoint the painting to Holly at a nil rate of IHT. (4) The gain on the appointment can be held over if the appointment is chargeable for IHT purposes (which will be the case unless the appointment is made in the first 3 months after the commencement of the settlement or in the first 3 months after the 10 th anniversary: IHTA 1984, s. 65(4)). (5) Hold over relief should, therefore, be available on the transfer into the trust, and on the appointment by the trustees to Holly. Trusts of business or agricultural property In many cases, the owner of business or agricultural property qualifying for business property relief (BPR) or agricultural property relief (APR), will not have any great incentive to settle such property during his or her lifetime: The owner can retain the property in the expectation that BPR or APR will be available on death. (a) The tax-free uplift on death, for CGT purposes, will apply. (b) If a lifetime transfer is made of property qualifying for relief, that relief may be clawed back, on the death of the settlor within 7 years, if the property is not retained by the trustees at the date of the settlor s death and/or if the property does not qualify for relief in the hands of the trustees. (c) If a farmer gives farmland to a trust, whilst continuing to live in the farmhouse, APR may cease to be available on his death, with respect to the 11

12 house, which will no longer be a farmhouse of a character appropriate to agricultural property, nor occupied for the purposes of agriculture (see Rosser v IRC [2003] STC 311). However, there may be a well-founded fear that BPR or APR will not be available, or not available to the extent of 100% of the value transferred, on the owner s death. 100% relief may be reduced to 50% relief by a future Government. There is also no clawback if the settlor survives for 7 years. The settlor may not need the business or agricultural property, and may want to bank the relief. IHT advantages where 100% relief It is possible to settle business or agricultural property, qualifying for 100% relief, up to any value, without any charge. The trust can also be continued for many years without any liability to exit or 10-year charges, so long as the qualifying property is retained. If 100% relief applies to the transfer into the settlement, and at the date of any exit or 10-year charge: (a) (b) (c) (c) (d) (e) The initial transfer of value by the settlor to the trust will be nil. Hold over relief under TCGA 1992, s. 260(2)(a) will be available in respect of any gain on the disposal into the trust, unless it is settlor-interested. On a distribution of agricultural or business property qualifying for relief, the amount on which the exit charge is based (diminution in value of the relevant property) will be nil: s. 65(2)(a) IHTA The gain can be held over provided that the distribution is not made in a quarter beginning with the commencement of the settlement or a 10-year anniversary (IHTA 1984, s. 65(4); TCGA 1992, s. 260(2)(a)). The 10-year charge will be nil, in respect of agricultural or business property qualifying for relief, since the rate is calculated by reference to a hypothetical transfer equal to the value on which tax is charged under s. 64, i.e. the value of the relevant property then comprised in the settlement (IHTA 1984, ss. 66(3)(a), (4)(a)). The value on which tax is charged is reduced by BPR (IHTA 1984, s. 103) and APR (IHTA 1984, s. 115). On a distribution after the 10-year anniversary, the value of the transfer will be nil in respect of any agricultural or business property qualifying for relief (s. 65(2)(a) IHTA 1984). The rate of tax on an exit after a 10 th anniversary is calculated as a fraction of the rate applicable on the 10-year anniversary (s. 69(1) IHTA 1984). This will be nil, if 12

13 the rate at the 10-year anniversary was nil (which will have been the case if 100% relief applied on that anniversary). TIP Trustees should consider acquiring business property more than 2 years before the 10 th anniversary so as to qualify for BPR on that anniversary. Conversely, trustees should be wary of selling property qualifying for BPR or APR before a 10 th anniversary or distribution. Sale of property qualifying for relief after 10-year anniversary The trustees of a relevant property trust owned land qualifying for 100% APR on the first 10 th anniversary of the commencement of the trust in In consequence, there was no IHT liability on the 10 th anniversary. The trustees sold the agricultural property in They now propose to distribute the sale proceeds. As the rate on the 10 th anniversary was nil, it follows that a nil rate will apply to the distribution after the 10 th anniversary of cash or other assets representing the sale proceeds of the agricultural property held on the 10 th anniversary. This is because the rate of an exit charge after a 10-year anniversary is a proportion (the appropriate fraction) of the rate charged at the previous 10-year anniversary (IHTA 1984, s. 69). TIP It would be advisable, if possible, to delay the sale of the agricultural property beyond a 10 th anniversary, and to distribute the sale proceeds before the next 10-year anniversary. 50% relief Augustus owns shares in a listed, trading company, which give him control of the company. Such shares qualify for 50% BPR (IHTA 1984, s. 105(1)(cc)). He wishes to settle the maximum number of shares without giving rise to a liability to IHT. He has made no chargeable transfers within the last 7 years. His annual exemption has already been used, and no other exemptions are available other than 50% BPR relief. The current nil rate band is 325,000. Augustus can settle 650,000 on relevant property trusts at a nil rate, since the reduced value of the transfer into the trust will be 325,

14 10-year and exit charges: 50% relief The trustees are considering distributing the whole trust fund shortly before the 10 th anniversary. The value of the shares, when settled, was 650,000 ( 325,000 after 50% relief). The value of the shares is 850,000 shortly before the 10 th anniversary, and will remain the same on the 10 th anniversary. The nil rate band is still 375,000 shortly before the 10 th anniversary, and on the 10 th anniversary. Care needs to be taken about distributing property, subject to 50% relief, before the 10 th anniversary. The value transferred will, it is true, be reduced by 50%. On the above example, the value transferred on such a distribution will be reduced from 850,000 to 425,000. However, the rate will be calculated by reference to a hypothetical transfer equal to the value immediately after the settlement commenced of the property then comprised in it (IHTA 1984, s. 68(4), (5)(a)). That value was 650,000. It is irrelevant that the value transferred into the trust was reduced by 50% to 325,000. IHT will, therefore, be payable on a distribution before the 10 th anniversary since 650,000 is greater than the available nil rate band of 375,000 (by 275,000). Therefore, a distribution of property, subject to 50% relief, before the 10 th anniversary may give rise to a charge, if 100% of the value initially comprised in the settlement is more than the available nil rate band. If the shares were retained until the 10 th anniversary, the position would be slightly better. The rate would be calculated by reference to a hypothetical transfer of the value of the relevant property in the settlement on the 10 th anniversary (IHTA 1984, s. 66(4)(a); 64(1)). This will be the value of the relevant property, reduced by 50%. On the above example, the value of the hypothetical transfer will be 425,000 (50% of 850,000) which would only exceed the nil rate band by 50,000. Clawback Trustees should be aware that IHT may become due in respect of a settlor s chargeable transfer of business or agricultural property to the trustees, if the settlor dies within 7 years of the transfer. In essence: (a) The trustees must retain ownership of the original business property at the date of the settlor s death, and that property must qualify for BPR on the settlor s death, although the 14

15 trustees do not need to have owned the business property for 2 years (IHTA 1984, s. 113A); and (b) The trustees must retain ownership of agricultural property at the date of the settlor s death; it must not be subject to a contract for sale; and throughout the period from the transfer to the settlor s death the property must have been occupied by the trustees or another for the purposes of agriculture (IHTA 1984, s. 124A). June 2010: Julius settles shares, worth 1.5M., qualifying for BPR (no charge to IHT). June 2011: The trustees sell the shares for 1.5M. and retain the cash. August 2012: Julius dies within 7 years of the settlement of the shares, so that the PET becomes chargeable. IHT at 40% will be payable in respect of the transfer by Julius to the trust of 1.5M (giving rise to a liability of 470,000 assuming a nil rate band of 325,000) because the trustees do not hold business property at the date of Julius death. The trustees will be liable for the IHT (IHTA 1984, s. 199(1)(b)). The trustees should, therefore, if possible, avoid selling agricultural or business property in the 7 years following a transfer of business or agricultural property, while the transferor is still alive, unless they acquire agricultural or business property replacing the original property (IHTA 1984, s. 113B, 124B). Alternatively, if the settlor has a short life expectancy, and it is likely that the qualifying property will be sold by the trustees soon after the settlor s death, the settlor should leave the qualifying property to the trustees by his will, rather than by a lifetime transfer. Relief will be available on the settlor s death, and will not be clawed back. In any event, the trustees should not distribute the sale proceeds without a retention for IHT and/or term assurance on the life of the intending settlor. Conditions for relief The conditions for APR and BPR must be satisfied by the trustees. Where relief depends upon ownership of business or agricultural property, the right to vacant possession, control of a business, or the carrying on of a business, by a transferor, it is the trustees who must own the property, have the right or control, or carry on the business. There should also be no contract for sale in place. 15

16 Where trustees hold property qualifying for APR or BPR, they must satisfy certain ownership/occupation requirements: (a) 2 year ownership (BPR); (b) 2 years occupation for the purposes of agriculture, or ownership for 7 years during which period the agricultural property must be occupied by some person for the purposes of agriculture (APR). However, these ownership and occupation requirements do not need to be satisfied if trustees became entitled to property which had qualified for APR or BPR on death (IHTA 1984, ss. 109 and 121). They do, however, need to be satisfied by the trustees of a lifetime trust. Ownership and occupation George settled agricultural property on lifetime discretionary trusts in 2013/14. The trustees let the agricultural property. The trustees appoint the agricultural property absolutely to George s son, Ben, in 2016/17. The appointment to Ben will not attract APR. The trustees will not have occupied the land for the purposes of agriculture for 2 years, nor owned for 7 years. The trustees would have made a chargeable transfer of the value of the agricultural property, and the rate would be calculated by reference to the value of the property comprised in the settlement after commencement, i.e. without any deduction for APR. The trustees should have waited for 7 years before making the appointment. Alternatively, they should have carried on the farm business themselves, appointing a farm manager. They would then have been in occupation for 2 years for the purposes of agriculture. No charge on settlement, but 10-year and exit charges It may be possible to get property into a trust, in excess of the nil rate band, at no charge to IHT. However, there may still be a concern that the trust property is subject to 10-year and exit charges. (a) George settles agricultural or business property, worth 1M., qualifying for 100% BPR/APR. The qualifying property is sold by the trustees after 7 years for 2M.and not reinvested in property qualifying for BPR/APR. There will be no charge on the creation of the trust. However, 10-year and exit charges will apply to the property representing the sale proceeds. APR/BPR will not apply. The rate of exit charge will be calculated by reference to the value, immediately after the settlement 16

17 commenced, of the property then comprised in it (IHTA 1984, s. 68(5)(a)), i.e. the unreduced value of the shares. On the 10 th anniversary, the charge would be calculated by reference to the value of the relevant property in the settlement. If this is cash, or other property not qualifying for relief, there will be a charge, as the value of the trust fund will no doubt exceed the nil rate band. (b) Penelope, who has recently been widowed, has surplus income of 100,000 per year. She settles 100,000 each year for 10 years on discretionary trusts for her children and grandchildren. The transfers into the settlement would not be transfers of value if made out of Penelope s income, as part of her normal expenditure, provided that Penelope is left with sufficient income to maintain her usual standard of living (IHTA 1984, s. 21). Penelope does not have to survive for 7 years. However, 10-year and exit charges would apply to the trusts. The cumulative total of the settlements made in later years would be nil since Penelope will have made chargeable transfers in the 7 years exceeding the nil rate band. (c) Charles settles 1M. on trusts for his wife and children pursuant to a Court order made in divorce proceedings. The transfer of 1M. into the trust does not give rise to a transfer of value because IHTA 1984, s. 10 (no gratuitous intent) or s. 11 (dispositions for maintenance of family) applies. However, the trusts will be subject to 10-year and exit charges. Pilot trusts In these circumstances, it has been common practice to recommend the use of pilot trusts. The settlor would settle nominal sums on a number of pilot trusts on consecutive days, and then make substantial further transfers to those pilot trusts on a later day. Day 1 10 to Trust 1 Day 2 10 to Trust 2 Day 3 10 to Trust 3 Day 4 10 to Trust 4 Day 5 249,990 (or property of that value) to Trust 1 249,990 (or property of that value) to Trust 2 17

18 249,990 (or property of that value) to Trust 3 249,990 (or property of that value) to Trust 4. Total settled: 1M. The transfers into the trust will not give rise to any charge if 100% APR or BPR applies; or there is no transfer of value because IHTA 1984, s. 10 (no gratuitous intent) or s. 11 (disposition for maintenance of family) apply; or the transfer is exempt because IHTA 1984, s. 21 applies. Alternatively, if these reliefs do not apply, the settlor may be prepared to accept an immediate charge to IHT at 20% above the nil rate band (grossed up if the settlor pays the IHT) on the 1M (less any annual exemption) transferred into the trust. 10-year and exit charges will apply to each of Trusts 1-4. However, each of Trusts 1-4 will have its own nil rate band, assuming that the settlor has not made any chargeable transfers within the 7 years prior to the creation of the Trusts because: (1) Trusts 1-4 are not related settlements with the result that they will not be treated as one settlement for the purposes of calculating the rate of IHT applicable to exit and 10- year charges. Two settlements (unless one is charitable) are related if and only if (a) the settlor is the same in each case, and (b) they commenced on the same day (IHTA 1984, s. 62). Trusts 1-4 were created on different days. (2) The addition of 999,960 to Trusts 1-4 by the same settlor on the same day (Day 5) does not render Trusts 1-4 related settlements. The settlements did not commence on the same day. The addition of 999,960 on Day 5 is not a new settlement commencing on Day 5: it is the addition of property to existing settlements, albeit that the additions are made on the same day. A settlement commences, for IHT purposes, when it is first made, notwithstanding later additions (IHTA 1984, s. 60, 61(1) and 66(2)). In consequence, the transfers of 249,990 to each of Trusts 1-4 on Day 5 will not be related settlements, as the additions will not be by way of new settlements made on the same day by the same settlor. (3) The establishment of the pilot trusts, and the addition of substantial funds, are not dispositions by associated operations as defined by IHTA 1984, s. 268, with the result that the settlements cannot be treated as being a single settlement for IHT purposes (Rysaffe Trustee Co (CI) v IRC [2003] STC 225). (4) Trusts 1-4 will, even after the addition of substantial funds, remain nil rate band trusts for the purposes of calculating the rate of IHT on exit and 10-year charges. This is because: 18

19 (a) (b) Only transfers made by a settlor prior to the commencement of the settlement, disregarding transfers made on the day of commencement, are taken into account in calculating the extent to which the nil rate band has been used up for the purposes of determining the rate of exit and 10-yearly charges (IHTA 1984, s. 68(4)(b) and 66(5)(a)). On the above example, the settlor did not make any chargeable transfers in the 7 years prior to the settlement of Trust 1 on Day 1. He made transfers totalling 30 (to Trusts 1-3) prior to the settlement of Trust 4 on Day 4. However, those transfers are within his annual exemption and/or are exempt as normal expenditure out of income. Where property is added to a settlement, the cumulative total of the settlement will be the aggregate value of the chargeable transfers made by the settlor in the 7 years ending on the day on which an addition is made, if this is greater than the value of the chargeable transfers made by the settlor in the 7 years prior to the commencement of the settlement (IHTA 1984, s. 67). However, additions made on the same day as each other are disregarded (IHTA 1984, s. 67(3)(b)(i)). Therefore, the cumulative total of each Trust will not take into account the value of the additions made to the other Trusts, as those additions will be made on the same day. It would be different if the additions were made on consecutive days (which should be avoided). (5) In consequence, a distribution before the 10 th anniversary will be charged at the nil rate (even though the total value of the property added to Trusts 1-4 was more than the nil rate band). (6) There will be no liability on the 10 th anniversary provided that the value of the property in each Trust is then less than the nil rate band (which should be the case as a result of dividing the sums settled between 4 separate settlements). (7) The Trusts can be merged into one Trust for administration purposes, by the Trustees of Trusts 1-3 appointing their respective trust funds to Trust 4. Each Trust will not lose its status as a separate nil rate band Trust because the respective Trust Funds will be treated as remaining comprised in the original Trusts (IHTA 1984, s. 81). The Consultation Paper and pilot trusts HMRC s Consultation Document, Inheritance Tax: Simplifying Charges on Trusts the next stage proposes changes to the taxation of relevant settlements which impact fundamentally on pilot trusts. 19

20 It is proposed that: (a) On the first 10-year charge the nil rate band will be split between all relevant property settlements made by the settlor and in existence at any time between the date the trust concerned was set up and the 10 th anniversary. This would include any settlements which had been wound before the 10th anniversary. (b) For subsequent 10 year charges the nil rate band will be split between all relevant property settlements made by the settlor and in existence at any time between the date of the previous 10 year anniversary and the date of the current charge. (c) For exits before the 10-year anniversary, the nil rate band will be split between all relevant property supplements in existence at any time during the period the trust concerned commenced to the date of exit. (d) For exits after the 10 year anniversary, the nil rate band will be split between all relevant property settlements which were taken into account for the purposes of calculating the last 10 year charge, plus any in existence since the 10 year anniversary to the date of exit. This will, in effect, do away with pilot trusts. Each of Trusts 1 to 4 (see Pilot trusts above) will share a single nil rate band equally on an exit or 10-year charge, even though they are not related settlements commencing on the same day. Trusts of an aggregate value, in excess of the nil rate band, will, in effect, be taxed as if there was one trust. It is proposed in the Consultation Document that the settlor s previous lifetime transfers be ignored in determining the available nil rate band. A full nil rate band (divided between the number of trusts settled by the same settlor) will, therefore, apply regardless of whether the settlor made chargeable transfers in the 7 years prior to the commencement of the settlement(s). The Consultation Document states that the new and simplified rules will apply from a given date and to any new trusts set up thereafter. It would, therefore, appear that they will apply to trusts set up on or after a date, probably in 2014, and to pre-existing trusts. However, it is not clear to what extent the changes will be retrospective, or whether there will be any transitional provisions. However, if the new legislation is retrospective, previous tax planning using pilot trusts will not be effective. 20

21 The winding up of, say, 3 out of 4 trusts before the 10 th anniversary will not prevent ¼ of the nil rate band being attributed to the 4 th trust on the 10 th anniversary, and the remainder of the nil rate band being attributed to each of the other 3 trusts equally on winding up. Other proposed changes It is also proposed in the Consultation Paper that: (a) Non-relevant property would also be ignored for the purposes of the calculation of periodic and exit charges. At present, the rate of IHT on an exit charge, and on a 10-year anniversary, is increased by the presence of non-relevant property, e.g. property settled on pre-22 March 2006 IIP trusts, in the same settlement. That will no longer be the case. This was a reason for avoiding mixed settlements of relevant and non-relevant property. However, in future, it seems that the rate will be calculated solely by reference to the value of relevant property. (b) A simple rate of 6% of the chargeable transfer is used in the calculation of periodic and exit charges. At present, the rate, applicable to an exit charge before the first 10-year anniversary, depends on the number of quarters which have expired since commencement. The formula is x/40 x 6%, where x is the number of quarters which have expired since commencement (IHTA 1984, s. 68). The maximum rate is 5.85% in the quarter before the 10 th anniversary (assuming that the nil rate band is exhausted). The rate applicable to an exit charge after the first 10-year anniversary also depends upon the number of quarters which have expired since the last 10-year anniversary (IHTA 1984, s. 69). The introduction of a flat rate of 6% will, therefore, increase the IHT payable on an exit charge. Self-settlements It is usual to exclude the settlor and the settlor s spouse or civil partner from benefit under a trust: (a) So as to avoid a gift with a reservation of benefit to the settlor for IHT purposes (FA 1986, s. 102). If a benefit is reserved to the settlor in settled property on the settlor s death, the settled property will be deemed to form part of the settlor s estate (FA 1986, s. 102(3)). (b) Because the gain on a disposal to a settlor-interested trust cannot be held over (TCGA 1992, ss. 169B-169G). A settlor-interested trust includes a settlement in which any property is or will or may become payable to or applicable for the benefit of the settlor or 21

22 his spouse or civil partner, or a child of the settlor at a time when the child is a dependent child of his. A dependent child means a child or stepchild who is under the age of 18 years, unmarried, and does not have a civil partner (TCGA 1992, s. 169F(4A)). (c) So as to avoid the income of the settlement being charged to the settlor, which will be the case where the settlor, the settlor s spouse or civil partner has an interest in settled property, except in limited permitted circumstances (ITTOIA 2005, s. 625). The income is taxed at the highest part of the settlor s income (ITTOIA 2005, s. 660C(3)). (d) So as to avoid a pre-owned assets (POAT) charge which can arise where a settlor disposes of an interest in land, which he occupies, or chattels of which he has possession or use; or where he has an interest in a settlement of intangible property (not land or chattels). However, there is no POAT charge if the settlor has reserved a benefit for IHT purposes (Finance Act 2004, Sch. 15, para. 11). Tax consequences In summary, the adverse tax consequences of a transfer to a settlor-interested trust are: (a) The transfer by the settlor into the trust will be immediately chargeable at 20% above the nil rate band, rising to a maximum of 40% on a death within 3-7 years. (b) There will be a reservation of benefit for IHT purposes with the result that the trust property will form part of the settlor s estate on his death if the settlor continues to reserve a benefit until death. (However, the Inheritance Tax (Double Charges Relief) Regulations 1987 provide for relief against the double IHT charge on both (a) and (b)). (c) The trust will be subject to 10-year charges and exit charges. (d) Hold-over relief will not be available on any gain arising on the disposal by the settlor of assets into the trust. (e) The income of the trust will be taxed as the settlor s income. (f) There will be no CGT-free uplift on the settlor s death. Self-settlement of the nil-rate band However, a self-settlement of the nil rate band may have advantages. Simon has made no chargeable transfers within the last 7 years. He settles 325,000 in cash on a life interest trust for himself, remainder to his children, but with no power to advance capital to him. The trustees invest in a buy-to-let property which produces an income for Simon. 22

23 The tax analysis is: (a) The transfer into the trust gives rise to no IHT liability, being within the nil rate band. (b) After 7 years the transfer will not form part of Simon s cumulative total for IHT purposes. (c) There is no gift with a reservation of benefit by Simon: he has given away a deferred right to capital, and retained a right to income. Simon will have carved out an interest, i.e. an interest in income for his life. He will have made a gift of the capital subject to his retained life interest, rather than giving away the whole beneficial interest and reserving a benefit out of what he has given away. (d) There will be no reservation of benefit under Finance Act 1986, s. 102A which would arise if Simon had made a gift of an interest in land, and he or his spouse or civil partner enjoyed a significant right or interest, or is party to a significant arrangement which entitles or enables Simon to occupy all or part of the land, or to enjoy some right in relation to all or part of the land, otherwise than for full consideration in money or money s worth. The gift will not be of land, but of cash. (e) On Simon s death his life interest will not be included as an asset in his estate as it arose after 22 March 2006 (IHTA 1984, s. 5(1), (1A)). However, there will not be a tax-free uplift on his death. A CGT charge will arise if a beneficiary becomes absolutely entitled. (f) 10-year and exit charges will be avoided if and so long as the trust remains a nil rate band trust. (g) There is no CGT charge on the disposal of cash into the settlement. (h) There is no POAT charge as that charge would only arise if Simon were in occupation of the property (which he will not be); or if the trust property is intangible property, other than land or chattels (which it is not: it is land). (i) The income will be taxed as Simon s income (but Simon receives the income anyway). Simon can, in this way, retain a right to income for life, but avoid IHT on the trust assets if he survives for 7 years. Loan trust Philip has a lump sum available for investment. He is not concerned to retain access to the capital growth of the investment. 23