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

24 However, he wishes to retain access to the income which he needs to meet his outgoings. Philip could: (1) settle 10 on flexible life interest trusts, or discretionary trusts, from which he would be excluded from benefit; and (2) lend 800,000 to the trustees interest-free but repayable on demand. The trustees would invest the trust fund, typically in a single premium investment bond, from which it is possible to reserve up to 5% annual capital repayments free of income tax. They would use these 5% withdrawals to part-repay the loan each year, thus meeting Philip s income requirements. The main tax advantages are: (a) The loan will not give rise to a transfer of value, as it will be repayable on demand. (b) The gift with a reservation provisions will not apply as there will be no gift and/or because Philip only benefits from the trust as a creditor. (c) HMRC accept that there is no POAT income tax charge because Philip will not be retaining a benefit under a settlement. (d) The 5% withdrawals will be free of income tax. (e) The loan repayments, being capital, will not be subject to income tax. (f) The loan repayments would not be subject to an IHT exit charge, as Philip is a creditor, not a beneficiary. (g) In respect of any 10-year, or exit charges, the value of the trust fund will be diminished by the amount of the loan. The key points are that: (a) Any growth in the value of the trust fund will be outside Philip s estate. (b) Philip can reserve an income which is not taxable and, if necessary, access to the full amount loaned (at the potential cost of an income tax charge). (c) The settlement and loan do not give rise to any tax liability. Possible disadvantages, or points to watch, are: (a) It is important that Philip spends the loan repayments, or at least gives them to individuals by way of transfers within his annual exemption or by way of a PET, so that they do not form part of his estate on death. (b) There is a risk that the value of the trust fund may not grow much, but will be subject to administration charges. In that event, there will be little or no benefit. 24

25 (c) Philip needs to survive for some years, so that the trust fund has a chance to increase in value significantly. (d) The loan, to the extent that it is not repaid and spent, will form part of Philip s estate. There may be a substantial sum outstanding which Philip does not actually need. If Philip does not have a surviving spouse, he cannot leave the benefit of the loan to her by way of an exempt transfer. (e) If Philip does need repayment of more than 5% in any one year, repayment may give rise to an income tax charge, if part of the bond has to be encashed in order to fund repayment. (f) Philip should ideally leave the benefit of the loan to his spouse (as this will be exempt) or, in any event, to a person who may not need to call in the loan in full (which could give rise to a substantial income tax charge if Philip dies soon after making the loan). Discounted gift trust Norma is 77. She is in reasonable health. She has two children, whom she would like to benefit. She is willing to part with 500,000 so long as she retains the income therefrom, which she needs to discharge her everyday costs of living. Norma could invest 500,000 in a life insurance bond (a discounted gift bond marketed by a number of financial services providers). This bond would be held by trustees and invested. The benefits payable under the bond would be segmented. There would, in effect, be two funds: one held upon a bare trust for Norma absolutely ( Norma s fund ); the other held on either discretionary or bare trusts for her children and grandchildren ( the beneficiary s fund ). Norma s fund would include the right to future capital payments on specified dates, if she is alive on each prospective payment date. Typically, the annual payments will be equal to 5% of the value of the bond, e.g. 25,000 per annum. A maximum 5% can be paid to Norma free of any immediate charge to income tax. However, she can choose a lesser rate of withdrawal. She can also choose whether to receive the sums monthly, quarterly, half-yearly, or yearly. The right to, and quantum of, these payments is, however, fixed for the rest of her life. The withdrawals will be free of IHT because they are held on a bare trust for Norma: there will be no exit charge as in the case of a relevant property settlement. Because Norma will have retained her fund, she will not have made a gift with a reservation of benefit in respect thereof. Nor will there be a reservation of benefit in respect of the beneficiary s fund because Norma will have no interest therein. HMRC accept (see IHTM44112) that no POAT 25

26 charge arises in respect of Norma s fund (because it will be held under a bare trust which is not a settlement for the purposes of FA 2004, Sch. 15, para. 8), nor in respect of the beneficiary s fund (because Norma will retain no interest therein). However, some commentators think that this is wrong: the bond is a single asset in which Norma has retained an interest. Norma could, therefore, provide 500,000 to be used to purchase a bond. She will be treated as having made a gift equal to 500,000 less the actuarial value of the rights retained by her of 25,000 per annum over her anticipated life expectancy having regard to her age, health and sex. In other words, she will be treated as having made a gift to the beneficiary s fund, of 500,000 less the value of her retained rights ( the discount ). If the value of the discount is 35%, she will have made a transfer of value of 325,000. If Norma makes a transfer of value of 325,000 to a relevant property trust, the value of that transfer will be within her rate band. No IHT will be payable in respect of the transfer, as it will be within the nil rate band. If she survives for 7 years, then the 325,000 will fall out of account for IHT purposes. This does limit the use of a discounted gift to the nil rate band, where the gift is to a relevant property settlement. 10-year and exit charges will be calculated by reference to the discounted value. However, on the 10 th anniversary, if Norma is still alive, the value of her fund will have diminished, and the value of the beneficiary s fund may well be worth more than the nil rate band (see Revenue & Customs Brief 22/2013: Discounted Gift Schemes - updated guidance on IHT valuations). Alternatively, Norma could make a gift of the beneficiary s fund to a bare trust for her children, rather than a discretionary trust, with the result that there will be a PET on commencement. In that case, there is no need to limit the gift to the nil rate band. There will also be no 10-year and exit charges. However, Norma will have no power to change the beneficiaries. The value the discount will have to be negotiated with HMRC if the beneficiary s fund is comprised in a relevant property trust; or in a bare trust, in the event that Norma fails to survive for 7 years. It will be necessary to obtain medical evidence as to Norma s health and life expectancy. The longer Norma s life expectancy is, and the less income she reserves for herself, the greater the discount. If Norma is in ill-health, the discount will be minimal, and a discounted gift scheme will be unsuitable. HMRC accept that Norma s fund ( 275,000) will not have any value for IHT purposes on her death, as Norma will on death cease to have any right to any further payments. That value will fall outside her estate even if she fails to survive for 7 years. However, some commentators consider that Norma s fund does have value immediately before her death because her impending demise is not 26

27 a known factor which a hypothetical valuer is to take into account. Of course, the actual payments received by her, to the extent that they have not been spent, will form part of Norma s estate on death. A discounted gift trust would not be suitable where the aim is to make an immediate gift of cash to Norma s children or grandchildren. Most schemes would not permit payments to the beneficiaries during Norma s lifetime, as the trustees may need to retain the whole fund for the purposes of making payments to Norma. Also if Norma gives up a right to capital withdrawals, she would be making a further transfer of value at that point, which would be a PET (in the case of a bare trust) and a ICT (in the case of a discretionary trust). Following Norma s death the beneficiary s fund will normally be wound up in favour of the beneficiaries and the bond encashed. If the beneficiaries are over the age of 18 and UK-resident, they will be liable for income tax on the increase in the value of the bond, adding back the payments made to Norma. However, credit is given for basic rate tax. Advantages and disadvantages of a discounted gift trust In summary, Norma can invest 500,000 in a bond and: (a) No IHT will be payable in respect of Norma s fund ( 275,000), whether or not she lives for 7 years, except to the extent that the capital payments to her are comprised in her estate on death. (b) No IHT will be payable in respect of the beneficiaries fund ( 325,000) if Norma survives for 7 years. (c) Norma can retain an income of 25,000 per year limited to 20 years (to avoid a chargeable event for income tax purposes). (d) Any growth in the value of the bond will be outside Norma s estate for IHT purposes. Such a scheme will be attractive: (a) If Norma survives for 7 years; (b) If Norma does not need to resort to the 500,000 (save as to the annual withdrawals); (c) If Norma needs the annual withdrawals to spend on outgoings; (d) If Norma s income and capital requirements are not likely to increase substantially; and (e) If the value of the bond increases by more than the value of the withdrawals. 27

28 If, say: (a) Norma survives for over 7 years (so that the value of the gift to the beneficiaries fund is exempt); (b) Norma does not survive for as long as her life expectancy, e.g. she survives for just over 7 years, whereas the discount was calculated on the basis that she had a life expectancy of, say, 15 years; (c) She has withdrawn 175,000 (which she has spent); (d) The bond, even after the withdrawals, is worth 500,000, 500,000 will pass to her chosen beneficiaries free of IHT on her death. However, she would have enjoyed the benefit of 175,000 (tax free) to meet her needs. It is not a disaster if Norma fails to survive for 7 years. If she died, unexpectedly, immediately after the creation of the trust, 275,000 would have been removed from her IHT estate. There are disadvantages to a discounted gift trust. There are costs in administering the trust/bond. The underlying investment is tied to a single investment bond. The amount of the annual payments are fixed. There is no resort to the capital, or to an increased income, if money is unexpectedly needed, e.g. to pay care home fees. The scheme is not, therefore, suitable for those who may want flexible access to capital or income. The scheme is also not suitable if Norma does not need and, therefore, does not spend, the capital withdrawals. She may live for 20 years, in which case the capital withdrawals will form part of her estate. The full value of the initial investment, as it stands at her death, will form part of her estate for IHT purposes. She would be better advised to make an outright gift. If, on the other hand, Norma lives for 20 years, and has withdrawn 5% per year of the initial value of the fund, there may be nothing left in the bond on her death for the benefit of her children. Indeed, the fund may even be exhausted before that date, if the investments lose value. A discounted gift trust is not suitable for an individual who is over 90, or who has a life expectancy of more than 15 years. It is most appropriate for persons, or married couples, in their 70s who are in reasonable health. The scheme can be adapted for use by married couples where, say, they both invest 250,000. However, it will be necessary to make two separate calculations of the value of the discounted gift made by the husband and the wife respectively. The discount will also be reduced by the 28

29 entitlement of the surviving spouse to capital payments from the share of the deceased spouse (which will pass by way of an exempt transfer for IHT purposes). Flexible reversionary trust Priscilla is aged 70. She has 500,000 in investments, and a pension from her late husband s former employers. Her income from her pension is presently sufficient for her needs. She would like to benefit her two children, but is concerned that she retains sufficient money to pay for care home fees, home help and/or medical assistance in her old age. A discounted gift trust would not be suitable. Priscilla has no present need for the capital withdrawals which would accumulate in her estate for IHT purposes. Her main concern is to have access to capital in the future if she needs to go into a care home (which she may not). A number of financial services providers market flexible reversionary trust schemes. The essential elements are: (1) Priscilla invests 325,000 (within her nil rate band) in 100 single premium policies with specified future maturity dates. 10 policies mature each year, or on specified future dates, e.g. Policies 1-10 in Year 2, Policy in Year 2 etc. (2) The policies are gifted to trustees, and invested in unit trusts or life assurance bonds, onshore or offshore, with multiple lives assured. (3) Priscilla retains the right to receive the sums payable under each policy, when each policy matures, thus reserving a right to income if she is still alive and needs the money. (4) Subject to Priscilla s retained rights, the benefits under the policies are held upon discretionary trusts for Priscilla s children and grandchildren, or on bare trusts for her children, in either case outside Priscilla s estate. Priscilla is excluded from any benefit. (5) The trustees meet each year to decide whether to exercise powers given to them to: a. defer payment of the sums due under the policy (if Priscilla has no need for the money); b. take no action (if Priscilla needs the money); c. cash in a policy before its maturity date; or d. appoint the benefits under the policy to the beneficiaries of the trust. (6) The trustees can allow the full value of each policy, including any investment growth, to revert to Priscilla on or before a maturity, or deferred maturity, date. 29

30 The tax analysis is as follows: (1) The initial creation of the trust will give rise to an ICT, if the trust is a discretionary trust. However, if the sum settled is 325,000, it will be within Priscilla s nil rate band. She can add further sums making use of the expenditure out of income and annual exemptions. 10- year and exit charges can apply, but will not be of great concern in the case of a nil rate band trust. This limits the sum settled to the nil rate band where a discretionary trust is used. (2) If the trust for the children and grandchildren is a bare trust, the creation of the trust will give rise to a PET. Priscilla can settle all her savings and investments ( 500,000) without giving rise to an immediate IHT charge. (3) If Priscilla survives for 7 years, the sum settled will not form part of her estate for IHT purposes. Taper relief applies after 3 years. (4) HMRC accept (perhaps rather generously) that Priscilla will not have made a gift with a reservation for IHT purposes, and that no POAT charge applies. If, however, she had given money to a discretionary trust, of which she was a beneficiary, there would have been a reservation of benefit. (5) The value of Priscilla s retained rights should be negligible as the trustees have power to appoint the benefits under each policy to the beneficiaries of the trust, or to defer the date of maturity. (6) No IHT charge arises where the trustees allow the sums payable under a policy to be paid to Priscilla (because they hold the policy upon trust for her as bare trustees). (7) No further IHT charge arises where the trustees defer payment of sums payable under the policies, or where they appoint in favour of the beneficiaries. Priscilla will not have made any disposition. In this way, Priscilla can give away a significant sum (not limited to the nil rate band in the case of a gift to a bare trust). If she survives for 7 years, the investments, representing the initial gift, will be free of IHT. Any growth is outside Priscilla s estate. After 7 years the whole process can be repeated. However, the trustees will have great flexibility in returning capital to Priscilla if she needs it. If she does not need the maturity proceeds, then her estate will not be swollen by the payment of monies which she does not spend. 30

31 Settlor s retained powers One feature of a flexible reversionary trust, as opposed to a discounted gift trust, is that there is no discount where the trustees are given power to defer or defeat the settlor s right to the proceeds of the policies on maturity. The value of the settlor s retained rights will, therefore, be nil. No element of the sum settled will immediately cease to have any value in the settlor s estate. The settlor needs to survive for 7 years in order for the full value of the trust fund to fall outside his or her IHT estate. This may not be a problem if the settlor is, say, in their 70s, and in reasonable health, with the result that they can expect to survive for 7 years. In any event, if the settlor is, say, 80, the discount will be diminished. Another feature of a flexible reversionary trust, as described above, is that the trustees (not the settlor) determine whether the maturity proceeds should be paid to the settlor, or not. The settlor does not have control over the decision. No doubt, reliable, independent trustees will be appointed, who can expect to respond favourably to any reasonable request for capital. However, the settlor may feel uneasy about surrendering control. With some flexible reversionary trust schemes, the power to decide whether or not the maturity proceeds should be returned to the settlor vests in the settlor, and the policy is on the settlor s life only. This will mean that there is a discount, as the settlor will have retained valuable rights. However, the downside is that there will be a PET (in the case of a bare trust) and an ICT (in the case of a discretionary trust) on each occasion that the settlor decides not to take his or her entitlement on maturity. TRUSTS ARISING ON DEATH Finance Act 2006 The Finance Act 2006 gives greater scope for the creation of non-relevant property trusts, arising on death, than it did in respect of lifetime settlements. A qualifying IIP can arise on death if the IIP is: a. an immediate post-death interest effected by a will or under the law relating to intestacy taking immediate effect on the death of the testator or intestate, not being a trust for a bereaved minor or a disabled person (an IPDI ); 31

32 b. a transitional serial interest which succeeds an IIP subsisting before 22 March 2006 ( TSI ); or c. a disabled person s interest, as defined in IHTA 1984, s. 89B. A testator can, therefore, create a qualifying IIP by Will if the IIP is an IPDI, or a disabled person s interest. Certain trusts in favour of children, arising on the death of a deceased parent, are neither IIP, nor relevant property, trusts, but are subject to their own special charging regime, i.e. a bereaved minor s trust ( BMT ) and an trust (IHTA 1984, s. 71A and 71D). Under a BMT and a trust, the trustees have a discretion as to whether to apply the income for the child, or to accumulate. However, the income can be payable as of right to a child beneficiary. In any event, such trusts are of limited application. They can only be created in favour of the children of a testator, and the capital must vest at 18 (in the case of a BMT) or at the latest 25 (in the case of an trust). Definition of IPDI Where a person (L) is beneficially entitled to an interest in possession in settled property that person s interest is an IPDI only if 4 conditions are met (IHTA 1984, s. 49A): Condition 1 The settlement must be effected by will or under the law relating to intestacy. Condition 2 The person entitled to the interest in possession (L) must have become beneficially entitled to it on the death of the testator or intestate. Condition 3 s.71a (bereaved minor trust) does not apply to the property and the interest is not a disabled person s interest. Condition 4 Condition 3 must be satisfied at all times since the interest in possession arose at death. A life interest taking immediate effect on death, for the benefit of a surviving spouse, will be an IPDI. The surviving spouse will be deemed to be entitled to the capital in which the IIP subsists, with the result that the transfer to the life interest trust for the surviving spouse, following the death of the deceased spouse, will be exempt. 32

33 Standard Will It has long been standard IHT planning for a married testator ( H ) to leave: (a) a nil rate band legacy to a discretionary trust for a class of beneficiaries including the surviving spouse ( W ), children and remoter issue; and (b) the residue to W absolutely, or on IPDI trusts. In this way: (a) W may benefit from the nil rate band trust during her lifetime, if she is in need; (b) There will be no IHT liability on H s death with regard to the nil rate band legacy; (c) The property in the nil rate band trust will not form part of W s estate on her death; (d) Distributions within the first 10 years of the trust will be at a nil rate for IHT, and the 10 year charge is likely to be small or non-existent; and (e) The residuary gift to W absolutely, or on IPDI trusts, will be exempt. Transferable nil rate band The advantages of a nil rate band trust have been somewhat diminished by the introduction of the transferable nil rate band. If H dies leaving the whole of his estate to W absolutely, or to W on IPDI trusts, no IHT will be paid on H s death (due to the spouse exemption). The whole of H s nil rate band will have been unused on his death. On W s death, W s personal representatives may, in effect, claim H s nil rate band. They will be entitled to double W s nil rate band on her death (IHTA 1984, ss. 8A-8C). W can have her cake and eat it. She can have the whole of H s estate (absolutely, or for life), but her estate will be entitled to two nil rate bands on her death. There is, therefore, arguably no need for a nil rate band trust. Discretionary trusts also have the disadvantage that income tax is payable by the trustees at 50% ( ) and at 42.5% on dividend income. Nil rate band trust v transferable nil rate band Given that the nil rate band is frozen at 325,000 until 2019, it may be still be advisable for H to settle 325,000 on a nil rate band trust in the hope that the value of the trust fund on W s death will have more than doubled. Cecil dies in 2013 leaving his whole estate to his wife, Margaret. His transferable nil rate band is 325,

34 Margaret dies in The nil rate band is then 375,000. Margaret will be entitled to a double nil rate band of 750,000. The assets settled on the nil rate band trust in 2013 ( 325,000) are worth 600,000 in 2022, when the nil rate band trust is wound up by transfer of the trust fund to Cecil and Margaret s children. If Cecil left the whole of his estate to Margaret, her nil rate band on her death would be 750,000, thus saving IHT at 40% of 750,000, or 300,000. If, instead, Cecil gave a nil rate band legacy of 325,000 to discretionary trustees: (a) A nil rate band of 325,000 would be available on Cecil s death; (b) 600,000 (the value of the trust fund in 2022) would be comprised in the nil rate band discretionary trust, and will fall outside Margaret s death on her death; (c) The nil rate band can be wound up, at a nil rate, on Margaret s death 9 years after the commencement of the trust on Cecil s death; and (d) Margaret s estate will be entitled to a single nil rate band on her death ( 375,000). As the value of the trust fund in 2022 ( 600,000) is worth more than a single nil rate band ( 375,000), it would have been better to have made use of a nil rate band trust, than to rely on a transferable nil rate band. However, this assumes that the value of the trust assets increases at a greater rate than the value of the nil rate band. Special reasons for using nil rate band Other potential attractions of a nil rate band trust in the case of a married testator (H) are: (1) If H has children by his first marriage, he may not want to leave the whole of his estate to W absolutely. (2) H may want to ensure that part of his estate (the nil rate band) is held on discretionary trusts for his children protected from claims by creditors, ex-spouses, or liability for care home fees. (3) H s spouse (W) may have independent resources so that she does not need a gift of the whole of H s estate on his death. (4) H may himself have two nil rate bands, totalling 650,000, because H s late, first wife had left all of her estate to H. H should not leave the whole of his estate to his widow (W). On W s death, she will only be entitled to a maximum of 2 rate bands (IHTA 1984, s. 8A(5) and (6)). She will not be entitled to 3 nil rate bands. H should leave one nil rate band to a discretionary trust, and the residue of his estate to W. W s estate will be entitled to two nil rate bands on her death. 34

35 (5) Property qualifying for BPR or APR should be given to a nil rate band trust, rather than to the surviving spouse. A gift to W would be exempt in any event, but the relief may be wasted if it is no longer available on W s death. TIP Property qualifying for BPR or APR should be left as a specific gift to the nil rate band trust, as opposed to a legacy of the maximum amount of cash which can be given without any liability to IHT with power to appropriate business and/or agricultural property in satisfaction of the legacy. If there is no specific gift, the benefit of the relief will be apportioned between the nil rate band trust and the exempt gift of residue to W (IHTA 1984, s. 39A). Avoiding an IPDI in the matrimonial home Cecil wishes to take advantage of a nil rate band discretionary trust, rather than leaving the whole of his estate to Margaret. However, his only asset of any value is his half share in the matrimonial home, Salcombe. If Cecil were to leave his half share in Salcombe to a discretionary trust, the danger would be that Margaret would acquire an IPDI in Salcombe by virtue of her occupation of Salcombe after Cecil s death (even though she has a right to occupy by virtue of her own half share). If that were so, the full beneficial interest in Salcombe would be treated as being comprised in Margaret s estate on her death. This would defeat the object of a nil rate band trust, which is to ensure that Cecil s share in Salcombe does not form part of Margaret s estate on her death. HMRC may argue that Margaret has an IIP in the nil rate band trust s half share in Salcombe on the basis that the trustees of the nil rate band trust have, in effect, permitted her to reside in Salcombe without payment of rent (SP 10/79). Furthermore, Margaret s IIP will be an IPDI, deemed to take immediate effect on Cecil s death, by virtue of IHTA 1984, s. 144, if Margaret has been permitted to occupy within 2 years of death. The trick, therefore, is to ensure that the trustees do not confer any occupation rights on Margaret within 2 years of Cecil s death. An IPDI can be avoided by taking the following steps: (1) The Executors should appropriate Cecil s half share in Salcombe to the nil rate band trustees only after 2 years have passed since Cecil s death. (2) The nil rate band trustees should, again outside the 2-year period, appoint a life interest in Salcombe to Margaret. 35

36 In those circumstances, the trustees will not have done anything within 2 years of Cecil s death to confer any occupation rights on Margaret. Indeed, Cecil s half share will not even form part of the trust fund during the 2-year period. Margaret will have been in occupation solely by reason of her own half share. Margaret will, therefore, acquire an interest in possession outside the 2-year period. However, this will not be an IPDI. The trust will be a relevant property settlement. The half share in Salcombe will not form part of Margaret s estate on her death. Increases in value will, therefore, be kept out of her estate. An added bonus is that principal private residence relief should be available, in respect of the trust s share, on the sale of the matrimonial home. When appointing a life interest to Margaret, the trustees should expressly confer a right of occupation on her for life. She will then be entitled to occupy under the terms of the settlement, and principal private residence relief should be available (TCGA 1992, s. 225). Unwinding a nil rate band trust One reason for including a nil rate band trust in a Will is that it can always be unwound, and the whole of the estate given to a surviving spouse, who will be entitled to claim the transferable nil rate band. Peregrine made a Will in 2010 leaving a nil rate band legacy to discretionary trustees for the benefit of his wife, Amanda, and his children and grandchildren. Peregrine left the residue of his estate to Amanda absolutely, or on life interest trusts. Peregrine died in In 2014 Amanda decides that she would like to have the whole of Peregrine s estate absolutely. An appointment out of a discretionary trust to a surviving spouse, made within 2 years of death, will be exempt by virtue of IHTA 1984, s That section applies to property settled by will, which has been appointed within 2 years of death, if the appointment would otherwise give rise to an exit charge (IHTA 1984, s. 144(1)). If such an appointment is made in favour of a spouse absolutely, or to a spouse on IPDI trusts, IHTA 1984 applies as if the will had provided that, on the testator s death, the appointed property had been given to the spouse absolutely. Such a transfer would be exempt as a transfer between spouses (IHTA 1984, s. 18). On this basis the nil rate band trust can be unwound in 2014: 36

37 (a) The trustees can appoint the trust fund to Amanda absolutely within 2 years of death (but not in the first 3 months: see the Frankland trap below). Peregrine will be deemed to have given the trust fund to Amanda absolutely by way of an exempt transfer taking effect on his death (IHTA 1984, s. 144). Peregrine s transferable nil rate band will, therefore, be available to Amanda s personal representatives. (b) Alternatively, the trustees could appoint the trust fund to Amanda on IPDI trusts within 2 years of Peregrine s death, giving rise to a deemed exempt transfer by Peregrine to Amanda (IHTA 1984, ss. 49, 144). The result will be that Amanda s estate will be entitled to Peregrine s transferable nil rate band, without any IHT charge arising on the appointment winding up the nil rate band trust. Amanda will be entitled to the whole of Peregrine s estate as of right. The appointment will give rise to a deemed CGT disposal since Amanda will become absolutely entitled to the trust property (TCGA 1992, s. 71(1)). Hold-over relief will not be available in respect of any gain arising since death. However, an appointment during the period of administration will not give rise to a CGT charge as it will be a disposal to a legatee at probate value (TCGA 1992, s. 62). A disposal after the completion of administration will be a disposal, but may well be of cash, which does not give rise to a chargeable gain. In any event, the increase in value since death may not give rise to a substantial gain. Frankland trap There is no exit charge where property ceases to be relevant property within 3 months of the commencement of the settlement, or of a 10-year anniversary (IHTA 1984, s. 65(4)). This means that any appointment out of a discretionary trust, made within 3 months of death, will not be retrospective for IHT purposes pursuant to IHTA 1984, s In the example given in the last section (Unwinding a nil rate band trust) the appointment to Amanda should not be made within 3 months of Peregrine s death. If the appointment is made to Amanda absolutely within 3 months of Peregrine s death, there would be no exit charge (IHTA 1984, s. 65(4)). IHTA 1984, s. 144 would not apply. Peregrine will not be deemed to have made an exempt transfer to Amanda on his death. This is the Frankland trap (named after the case of Frankland v IRC [1997] STC 1450 where the trustees of a discretionary trust made an appointment to the surviving spouse within 3 months of death). The spouse exemption will not be available. IHT would still have to be paid on Peregrine s death as if he had made a chargeable transfer of the settled property. 37

38 TIP In the case of an appointment out of a discretionary will trust, to a spouse absolutely, the appointment should be made after 3 months from death, but before 2 years. However, if the appointment were made to the spouse upon IPDI trusts (but not on disabled trusts) within 3 months of death, IHTA 1984, s. 144 will apply, and there will be a deemed exempt transfer (IHTA 1984, s. 144(3)). Will leaving IPDI for spouse Christine leaves her residuary estate on life interest trusts for her husband, David, remainder to her children by her first marriage. The trustees have power during David s lifetime to appoint capital to David, if he needs it, or to terminate David s interest in whole or in part in favour of the children. The tax consequences are: (a) David will be entitled to an IPDI. (b) An IPDI is a qualifying interest in possession with the result that David will be treated for IHT purposes as beneficially entitled to the property in which the interest subsists (IHTA 1984, s. 49(1)). (c) Christine will, therefore, be treated as having made on her death an exempt transfer of the settled property to David. No IHT will be payable on Christine s death. (d) On David s death the settled property will form part of his estate (IHTA 1984, s. 4, 5). David will acquire Christine s transferable nil rate band if the whole estate has been settled upon David for life. There will be no exit and 10-year charges during David s lifetime. There will be a CGT-free uplift on David s death. In this way, Christine s estate (or residuary estate) can be left to David upon life interest trusts, free of IHT. There will be no 10-year charges while the trust property remains settled during David s lifetime. However, Christine can ensure that the trust property passes to her children on David s death (subject to any advances or appointments made by the trustees). If appropriate, an IPDI trust can always be unwound by an appointment by the trustees to David absolutely without any charge to IHT (IHTA 1984, s. 53(2)). However, hold-over relief will not be available. 38

39 Termination of IIP of spouse Edmund has died leaving his residuary estate to his wife, Florence, for life. Florence is losing capacity, but has a reasonable life expectancy. She may need to go into a care home. Edmund and Florence have two adult children, who both have young children. Florence s life interest can be terminated by the trustees in favour of the adult children. Florence will be treated as having made a transfer of value equal to the value of the property subject to the IPDI (IHTA 1984, s. 52). However, the termination will be a PET being in favour of an individual or individuals (IHTA 1984, s. 3A(1A)(c)(i)). There is, therefore, the opportunity to save IHT, if Florence survives for 7 years. Edmund could have left his estate to Florence absolutely, and she could make PETs herself. She would then have retained control. However, if she is likely to lose capacity, an IPDI trust is a better option. It will safeguard against the danger that Florence may make gifts at a time when her capacity is in doubt. There will be no need for an application to the Court of Protection to approve gifts to the children. The assets of the trust (other than any income actually paid to Florence) will also not be immune from any liability to contribute to care home fees. TRAP Edmund should not leave his estate to Florence absolutely expressing a wish that she should transfer the whole or part of it to the children, even if Florence is in good mental health, and can be trusted to carry out Edmund s wishes. If Florence transfers the property within 2 years of Edmund s death, IHT would be charged as if Edmund had left the property directly to his children (IHTA 1984, s. 143). The spouse exemption will be lost, and Florence will not have made a PET. It would have better to have left the chattels on terminable IIP trusts for Florence. Termination of IIP of 2 nd spouse Carl is aged 80. He is married to Georgina, who is a youthful 47. Georgina has money of her own. Carl has children of his first marriage, whom he wishes to benefit on his death. Carl might be advised to make a Will leaving his residuary estate upon trust for Georgina for life, but giving the trustees an overriding power of appointment in favour of a class of beneficiaries, 39

40 including Carl s children. No IHT would be payable on Carl s death, as Georgina would have an IPDI, and the transfer on death would be exempt as between spouses. Shortly after Carl s death, the trustees could terminate Georgina s life interest in whole or in part in favour of the children absolutely, giving rise to a PET. If Georgina survives for 7 years (as is likely) no IHT will be payable on the appointments in favour of the children. Carl s estate will have passed to his children, free of IHT, which would not have been the case if he had left his estate directly to them on his death. Indeed, Carl might leave a letter of wishes asking the trustees to terminate Georgina s life interest, in whole or in part, soon after Carl s death, in favour of his children, if appropriate. TRAP The trustees would, in the case of a termination of Georgina s life interest, exceeding the nil rate band, need to insure against Georgina s death within 7 years and/or make a sufficient retention to pay the IHT liability in that event. Georgina s own nil rate band would also be used up if she then fails to survive for 7 years. She might wish to leave her estate to person s other than Carl s children, such as her own children by her first marriage. Her nil rate band might be exhausted following the termination of her IPDI in favour of Carl s children. It might, therefore, be appropriate to consider the inclusion of a legacy to Georgina s children. Reservation of benefit The trustees of a life interest trust for Georgina terminate her life interest in the matrimonial home which Carl owned outright in favour of his children. Georgina continues to live in the matrimonial home. The termination of Georgina s life interest during her lifetime is deemed to be a gift by Georgina of the settled property in which the interest in possession subsisted (Finance Act 1986, s. 102ZA). This is so even though Georgina will not herself have made a gift: her interest will have been terminated by the trustees. Georgina will have reserved a benefit in the matrimonial home by virtue of her occupation. On her death the home will form part of her estate, even if she has survived for 7 years since the termination of her interest. 40

41 TIP Georgina will not be treated as having made a gift, on the termination of her interest, for the purposes of Finance Act 1986, s. 102A (which applies to a gift of interest in land occupied by a donor who has retained an interest), as opposed to s. 102 (general reservation of benefit provision). The trustees could grant a 20-year lease in the matrimonial home to a nominee for themselves, at no rent, and then terminate Georgina s interest in possession in the freehold reversion in favour of her children absolutely. Georgina will be deemed to have made a PET of the value of the freehold reversion. Principal private residence relief will be available on the disposal. Georgina will retain an IIP in the lease. However, there will be no reservation of benefit in respect of the freehold reversion because: (a) Georgina will not have made a gift with a reservation, for the purposes of FA 1986, s. 102, as a lease will have been carved out prior to the gift of the freehold; and (b) Although Georgina will be deemed, by FA 1986, s. 102ZA, to have made a gift of the freehold reversion, on the termination of her life interest, that will not be the case for the purposes of FA 1986, s. 102A (which counters carve-out schemes where there is a gift of land). Nor will she have disposed of an interest in land for the purposes of a POAT charge. Georgina can, therefore, continue to occupy by virtue of her lease (the value of which will diminish over time) without a reservation of benefit. There will, however, be a CGT charge, in respect of the children s freehold reversion, on the eventual sale of the house. However, the scheme can be modified to avoid such a charge, by Georgina retaining a 5% interest in the freehold reversion, the other 95% being appointed to the children. General power of appointment Oliver proposes to make a Will conferring a life interest on his spouse, Catherine. They have only one son, Richard, who is something of a spendthrift. They do not want Richard to become absolutely entitled to Oliver s estate on Catherine s death (assuming that she survives Richard). They would prefer that he had a right to the income for life, with the possibility of the trustees advancing capital to him or his children, and that, subject to such advances, the capital is preserved for his children. 41

42 The problem is that, on Catherine s death, Richard will become entitled to an IIP if he has is given a life interest, following on from Catherine s life interest. However, his IIP will not be an IPDI, since his IIP did not arise on Oliver s death. The IIP trust will be a relevant property settlement, subject to 10-year and exit charges. TIP Oliver could, by his Will, give Catherine, a general power of appointment exercisable by her Will in favour of any person. If she exercises that power to settle the trust fund, after her death, on trust for her Richard for life, Richard would become entitled to an IPDI outside the relevant property regime. Alternatively, even if Catherine is not given a general power of appointment, the trustees could appoint the trust fund to Catherine absolutely with no IHT charge (IHTA 1984, s. 53(2)). Catherine can then set up an IPDI trust under her will in favour of Richard. Another possibility is for Oliver s Will to provide that, following Catherine s death, there be a discretionary trust for Richard, and his children, and their spouses. The trustees can make an appointment to Richard absolutely, or on such trusts as they deem appropriate, within 3 months of death without any IHT charge (IHTA 1984, s. 65(4)). Generation skipping Arthur is a widower. He has one adult child, Isabelle, who is married, and well provided for. He has two grandchildren aged 21 and 23. Arthur could leave his estate, or a substantial legacy, to trustees upon flexible IIP trusts for his grandchildren. Their interests would qualify as IPDIs. This should mean that no IHT will be payable for many years, i.e. until the deaths of the grandchildren. No 10-year, or exit charges, will apply during the currency of the trust. However, the trustees could retain control over the capital and/or limit income by investing in low or non-income producing assets. The trustees could, in due course, advance the capital of their share to the grandchild absolutely, without giving rise to any charge to IHT (IHTA 1984, s. 53(2)). However, there would be a CGT disposal, the gain on which cannot be held over, unless the assets qualify for business hold-over relief pursuant to TCGA 1992, s

43 A direct gift to an IPDI trust for grandchildren may be preferable to an IPDI trust for Isabelle which can be terminated by the trustees in favour of the grandchildren by way of a PET. The PET may fail if Isabelle does not survive for 7 years. Reservation of benefit issues are also avoided. Bereaved minor s trust ( BMT ) Jessica is a widow. She has a child, Tim, aged 3. She wishes to leave the whole of her estate (which exceeds the nil rate band) to Tim. Jessica dies when Tim is 4. Jessica could make a Will leaving her estate to Tim contingently on attaining the age of 18 years. So long as the Will provides that: (a) The capital and income vest at 18; and (b) While Tim is living and under the age of 18: a. capital can only be applied for his benefit; and b. Tim is either entitled to the income (if any), or no such income may be applied for the benefit of any other person. the trust will qualify as a BMT within IHTA 1984, s. 71A. If Tim is entitled the capital at 18, but is given an immediate entitlement to income (s. 31 of the Trustee Act 1925 being excluded) the trust can still be a BMT. There are IHT advantages: (a) There will be no IHT charge on Tim s death before 18; (b) There will be no 10-year or exit charges while Tim is under the age of 18: there will, therefore, be no 10-year charge when Tim is 14; (c) There will be no exit charge on Tim becoming entitled to the settled property at 18, or to an interest in possession in the settled property, on or before attaining the age of 18. The trust will, in effect, be IHT-free until Tim attains the age of 18. Hold-over relief is also available on any occasions when Tim becomes absolutely entitled (TCGA 1992, s. 260(2)(da)). There can be a bereaved minor s trust for a number of bereaved minors provided that they are alive at the date the trust takes effect and under the age of 18. The shares of each minor can be 43

44 unequal, and can be varied. The trust can include a power of advancement over the whole trust fund. However, bereaved minor s trusts are not particularly attractive: (a) The bereaved minor must be a child of the testator (thus excluding grandchildren). (b) The child must be entitled to the trust capital at 18 (which may be regarded as too young an age). However, the trustees can exercise a power of advancement, provided that they consider that is for the benefit of the child, to defer capital entitlement for a period beyond 18 (see Wright v Gater [2011] EWHC 2881 (Ch)).There will be no IHT charge on the making of such a settled advance (IHTA 1984, s. 71B(2)(c)). However, the trust will then be subject to the relevant property regime (unless it qualifies as an trust). (c) There is limited flexibility: a. Income and capital cannot be paid to anyone other than a bereaved minor; b. A bereaved minor cannot be revocably excluded from benefit, and then reinstated before the age of 18. c. A bereaved minor s share cannot be increased or decreased once he has attained the age of 18. No overriding power of appointment can be included so that a bereaved minor s absolute entitlement at 18 can be defeated trusts Jessica does not want Tim to be entitled to her estate at 18. She wants to leave her estate (which exceeds her nil rate band) to Tim on attaining the age of 25. Tim is 4 when Jessica dies. Jessica can leave her estate to Tim contingently on attaining the age of 25. Such a trust can qualify as an trust, introduced by IHTA 1984, s. 71D in order to counter the criticism that the vesting of capital at 18 is often inappropriate. However, trusts can only be set up by a Will, and the testator must be the parent of the beneficiary. Tim must become entitled to the capital on or before attaining the age of 25. Capital and income cannot be applied for the benefit of anyone other than Tim while he is under the age of 25. Tim can become entitled to the income at 18. However, he must not become entitled to the income immediately after Jessica s death. In that event, he will have an IPDI, which takes precedence 44

45 over an trust. The Will should, therefore, give the trustees power to accumulate income, or to apply it for the benefit of Tim, but no other person, until he is 18, or 25. As in the case of a bereaved minor s trust, an trust can be for the benefit of a number of beneficiaries, and can include a power of advancement. While Tim is under the age of 18, the trust is exempt from IHT as is the case with a BMT. There will be no 10-year charge when Tim is 14, nor any charge on distributions for his benefit while he is under the age of 18. There is no 10-year charge when Tim is 24 since no 10-year charge can arise when the beneficiary is aged between 18 and 25. However, there will be an IHT charge under IHTA 1984, s. 71F(2), if, after Tim has attained the age of 18: (a) Tim becomes absolutely entitled to the trust property; (b) Tim dies; or (c) property is advanced for the benefit of Tim. The charge is calculated in the same way as an exit charge under the relevant property regime. The rate increases depending upon the number of quarters which have passed since the beneficiary s 18 th birthday. The maximum charge is 4.2% if the beneficiary becomes entitled to capital at 25. The rate can only be as much as 4.2% if the testator s cumulative total in the 7 years before death exhausted the nil rate band. This introduces a degree of flexibility. The trustees can: (a) advance to Tim at 18 without any IHT charge; (b) advance at any age between 18 and 25; or (c) advance at 25. The longer they wait, the higher the charge. However, the rate will be zero if the aggregate value of the following does not exceed the nil rate band as at the date of the exit charge: (a) the testator s cumulative chargeable transfers in the 7 years before death; (b) the initial gross value of the trust; (c) the initial gross value of any related settlement; (d) the gross value of any additions to the settlement. 45

46 There is the added advantage that hold-over relief will be available on the beneficiary becoming absolutely entitled on or before attaining the age of 18 (TCGA 1992, s. 260(2)(da)) or between 18 and 25 (TCGA 1992, s. 260(2)(a)). There is yet further flexibility in that the trustees can make a settled advance postponing entitlement to capital beyond 25, albeit at the cost of an exit charge. The continuing trusts will be within the relevant property regime subject to 10-year and exit charges. Conclusion on bereaved minor and trusts An trust (with the potential to defer entitlement beyond 25 by a settled advance into a relevant property trust) is probably preferable to a bereaved minor trust. It defers capital entitlement at little or no cost. However, both forms of trust are only going to assist in the comparatively rare case where a parent dies leaving young children, but does not want to leave the whole of their estate to a surviving spouse absolutely or on IPDI trusts. A discretionary trust might be preferable where the value of the settled property is within the nil rate band. It is more flexible. IPDI trusts for minor children of the testator As an alternative to an trust, a flexible IPDI trust for minor children should be considered. In this way, capital entitlement can be deferred beyond 25 for the whole life of the child. Jessica leaves her residuary estate on flexible life interest trusts for Tim. Tim is 4 when Jessica dies. Tim will become entitled to an IPDI on Jessica s death, even if he is under the age of 18. Tim would have an IPDI which would be outside the relevant property regime for the remainder of his life, assuming that the trust continues. There would be no IHT charge if the capital of Tim s share is advanced to him absolutely (IHTA 1984, s. 53(2)). Tim will not be able to give good receipt for income until he is 18. Trustee Act 1925, s. 31 should be excluded, so that the trustees have no discretion to accumulate income (which would be inconsistent with an IPDI). Tim will be able to give good receipt in respect of income at 18. However, the trustees can, if the trust deed gives them power to do so, invest in assets which produce little or no income. Tim will 46

47 not have a right to the capital on or before attaining the age of 25 (as in the case of an trust). The trustees can advance capital to him at a later age, or even advance on trusts for his children. A disadvantage of an IPDI trust, as against an trust, is that hold-over relief will not be available on Tim becoming absolutely entitled unless the assets are business assets within TCGA 1992, s Also Tim s death under the age of 18 will give rise to a chargeable transfer at the full death rates. However, these disadvantages may not be significant. In the case of minor grandchildren, an IPDI is a good option. It should defer payment of IHT for many years (see Generation Skipping, above). Discretionary trusts of residue Pierre is single, or married but his wife is unlikely to survive him. He has a substantial estate. He has various friends and relatives, and also wishes to benefit certain charities. However, he does not know what his estate may be at death, whether his wife, or his friends and relatives, will survive him, or what their circumstances may be when he dies. The effect of IHTA 1984, s. 144 is that any distributions out of a discretionary trust created by a Will within 2 years of death (but not in the first 3 months) are treated as if they had been effected by the testator at the time of death. The application of the section is automatic. The power of appointment must be exercised before an interest in possession subsists in the settled property. It might, therefore, be advisable to provide that the income should be accumulated for 2 years. There is no need to provide that the trust should terminate after 2 years. However, the trust could provide that the trustees must exercise their power of appointment within 2 years with a gift in default. The power should be exercisable prior to the grant of probate. Advantages The advantages of a discretionary trust which is terminated within 2 years of death are: (1) Flexibility The trustees can decide, having regard to circumstances after Pierre s death, and any letter of wishes, how best to distribute the trust fund, e.g. by: 47

48 a. appointing a life interest in whole or part of the trust fund to an exempt beneficiary, such as a charity or a surviving spouse, absolutely within 2 years of death (which will be exempt); or b. appointing an IPDI within 2 years of death to a younger beneficiary (thus taking the trust out of the relevant property regime and deferring any further IHT charges to IHT for many years); or c. appointing, or not appointing, to any beneficiary dependent upon circumstances such as financial need, bankruptcy, divorce etc. (2) Business or agricultural property Terence owns a farmhouse and some land, or some shares. He is not sure whether they will qualify for APR or BPR. He is married to June, and has a number of children. George should leave such property to a discretionary trust. If, within 2 years of death, it becomes apparent that relief is available, the relieved property can be appointed to the children without any liability to IHT, making use of IHTA 1984, s If, on the other hand, relief proves not to be available, the property can be distributed to June, so that the spouse exemption applies. Disadvantages There are, however, a number of disadvantages to, and points to watch in respect of, a 2-year discretionary trust: (1) The testator will be giving control over the distribution of his estate to third parties. However, no doubt he will select trusted, responsible trustees. He can also leave a letter of wishes. (2) An appointment to a surviving spouse or charity absolutely within 3 months of death will not be exempt for IHT purposes because s. 144 only applies where there is an exit charge under the discretionary trust regime, which there cannot be within 3 months of death (s. 65(4) IHTA 1984; Frankland v IRC [1997] STC 1450; Harding v IRC [1997] STC 321). However, an appointment upon IPDI trusts for a spouse will be exempt even if made within 3 months of death (IHTA 1984, s. 144(3)). It is also possible to create a bereaved minor s trust or trust by an appointment made within 3 months of death. (3) CGT hold-over relief under s. 260(2)(a) IHTA 1984 will not apply to distributions within the 2-year period after death with the result that any gain since death will be taxable. However, an appointment made during the 2-year period, prior to the completion of administration, is 48

49 treated by HMRC as a disposal to a legatee at probate value, with the result that no CGT will be payable until the legatee disposes of the asset. (4) Full IHT has to be paid prior to the grant of probate, even if there is subsequently a distribution which is exempt, e.g. to a spouse. This may give rise to cash flow problems unless the power of appointment is exercised prior to the grant. By contrast, no IHT will be payable if the estate is settled upon flexible life interest trust for the surviving spouse. Discretionary trust beyond 2 year period and pilot trusts Pierre may want the option for the discretionary trust to continue for longer than 2 years. His estate is worth 3M when he dies. He is not survived by his spouse. He leaves 3.25M on discretionary trusts for friends and relations. The nil rate band on his death is 325,000. The concern will be that, if the trust is not wound up within 2 years of death, the value of the settled property will exceed the nil rate band, with the result that exit and 10-year charges will arise. These charges could not be avoided by Pierre leaving 325,000 to 10 separate trusts. Those trusts will be related settlements because they will have been made by the same settlor (Pierre) on the same day (his death). Pierre could set up 10 discretionary, pilot trusts created by him on different days during his lifetime (see Pilot Trusts, above). Each trust will have its own nil rate band. He could then make 10 legacies in his Will, equal to the nil rate band, to each of the pilot trusts. The legacies would be additions made to existing settlements made on the same day, with the result that, under the law as it stands, each trust will have its own nil rate band (see Pilot Trusts, above). However, if the proposals in the Consultation Paper are implemented, the use of pilot trusts to avoid 10-year and exit charges will not be effective. Trust for a disabled beneficiary Graham wishes to leave a tax free legacy of 500,000 to his daughter, Clara. 49

50 Clara is a disabled person within the meaning of FA 2005, Sch. 1A in that she is a person who by reason of mental disorder within the meaning of the Mental Health Act 1983 is incapable of administering his or her property or managing her affairs. Graham would like to avoid or minimise IHT, CGT and Income Tax charges as much as possible. He also wishes to preserve the benefit of means-tested benefits for Clara. There are a number of options: (1) A disabled person s trust for Clara within IHTA 1984, s. 89 (as amended by FA 2003, Sch. 44, para. 6); (2) IPDI trusts for Clara, including a provision in the Trust Deed that the Trustees need not invest in income-producing assets; (3) A discretionary trust for a class of beneficiaries, including Clara, perhaps coupled with a letter from Graham to the Trustees that, during Clara s lifetime, he would like her needs to be given primary consideration, if possible without prejudicing her entitlement to meanstested benefits. IHTA 1984, s. 89 Graham can set up a will trust for Clara within IHTA 1984, s. 89 by leaving 500,000 free of tax to trustees upon trusts which provide that: (a) The trustees will, while Clara is alive, pay the income to her or for her benefit, or shall accumulate such income; (b) The trustees may apply capital to or for Clara s benefit during her lifetime; (c) Subject as above, the trustees shall hold the trust fund on discretionary trusts for the members of an appointed class; and (d) The trustees have an extended statutory power of advancement under Trustee Act 1925, s. 32. Clara will be deemed to have a qualifying IIP for IHT purposes even though the trustees have a discretion to accumulate income. The advantages are: (a) As she will have no entitlement to income or capital, Clara will not have assessable income or capital for the purposes of means-tested benefits, unless and until such income or capital is actually paid or transferred to her. (b) Clara will have no right to capital or income during her lifetime (which is desirable given that she is incapable of managing her affairs). (c) The trust will not comprise relevant property subject to 10-year and exit charges. 50

51 (d) Payment of capital to Clara will not give rise to an IHT charge (IHTA 1984, s. 53(2)), and the application of capital for her direct benefit will probably be treated in the same way (although s 53(2) does not expressly include this). (e) The trust will qualify for a full annual exemption for CGT pursuant to TCGA 1992, Sch. 1, para. 1 (as amended by FA 2013, Sch. 44, para. 13). (f) The trusts will be qualifying trusts for a vulnerable beneficiary within Finance Act 2005, ss (as amended by FA 2013, Sch. 44), so that, subject to making an election, and claiming special tax treatment in any tax year, the income and gains will be treated as being those of Clara (making use of her lower, personal rates). However, the disadvantages are that: (a) The trust fund will form part of Clara s chargeable IHT estate on her death taxable at 40% above the nil rate band. (b) It will not be possible to claim hold-over relief in respect of any gain on a deemed disposal arising when Clara becomes absolutely entitled to trust property (TCGA 1992, s. 71). (c) There will be no CGT-free uplift on death. These disadvantages could be significant if the trust fund has increased in value significantly by the date of Clara s death, or by the date of her absolute entitlement, and/or if the value of the trust fund is well in excess of the nil rate band. However, during Clara s lifetime, a disabled person s trust will be free of IHT, and is generally taxefficient for CGT and income tax purposes. IIP trust The advantage of an actual IIP trust (whereby the income, if any, has to be paid to Clara during her lifetime) is that the CGT-free uplift on death applies (which is not the case in respect of a disabled person s trust complying with IHTA 1984, s. 89). However, the trust deed would have to be provide that the trustees will have full power to invest in assets which produce little or no income (so as to preserve entitlement to means-tested benefits). Discretionary trust The advantages of a discretionary trust are that: There is no charge on Clara s death at 40% above her nil rate band, only an exit charge if the trust fund ceases to be settled (which may be minimal, particularly if the value of the trust fund does not much exceed the value of the nil rate band). It will be possible to hold over any gain on Clara becoming absolutely entitled to trust property pursuant to TCGA 1992, s. 260(2)(a)). 51

52 The disadvantages are: 10-year and exit charges will apply (which will be of greater concern if Clara has a long life expectancy and/or the value of the trust fund significantly exceeds the nil rate band, but will be of little or no concern if the initial value of the trust fund does not exceed the nil rate band). It will not be possible to make a vulnerable beneficiary s election so that any gains will accrue to the trustees at their rate of 28%, and income will be taxed on the trustees at a rate of 42.5% on dividend income, and 50% on other income. There is no CGT-free uplift on death. 52