The recent Royal Assent of the 2006 Finance Act has confirmed the far-reaching changes to trust taxation announced in the Budget last March.
Prior to the Budget, gifts to Interest In Possession (IIP) and Accumulation & Maintenance (A&M) trusts were Potentially Exempt Transfers (PETs), so Inheritance Tax (IHT) only became payable should the settlor (the creator of the trust) die within seven years of making the gift. The new rules mean gifts to these two types of trust are now treated as Chargeable Lifetime Transfers (CLTs), bringing their IHT treatment in line with that of Discretionary trusts. In addition to this entry charge a ‘Periodic Charge’, levied at each ten year anniversary, and exit charge, levied when trust assets are distributed, may also apply wherever the value of the assets exceeds the current nil rate band (£285,000 for 2006/07).
| "Despite the Government claiming only a small minority will be affected by these changes, it’s likely many could feel the impact. " |
Despite the Government claiming only a small minority will be affected by these changes, it’s likely many could feel the impact. The Law Society says, “…the changes will hit ordinary people hard” while Skandia estimates over half a million trusts could be affected.
Chargeable Lifetime Transfers – an example
IHT will be payable at the lifetime rate (20%) on the cumulative total of any CLTs made in the previous seven years that are in excess of the current nil rate band. Further IHT tax may be due if the settlor dies within seven years.
Consider Mr & Mrs Jones, who both gift £250,000 into Discretionary trusts. In the previous seven years Mr Jones had made no other CLTs and therefore there is no immediate IHT charge as the gift of £250,000 is less than the current nil rate band of £285,000. Mrs Jones however made another gift of £150,000 to a Discretionary trust two years ago. The cumulative total of her gifts over the last seven years therefore is £400,000. As this exceeds her nil rate band by £115,000 it will give rise to a tax charge of £23,000 (20% x £115,000).
Periodic Charge – an example
Let’s assume that on the tenth anniversary of the trust Mr Jones’ gift has now grown to £500,000, that there have been no distributions of capital during these ten years and the nil rate band is now £400,000. The periodic charge will be calculated as follows:
Value of trust property in excess of nil rate band (VT) = Value of trust property - Nil rate band = £500,000 - £400,000 = £100,000.
Tax on trust property = VT x 20% (lifetime rate) = £100,000 x 20% = £20,000.
Effective rate = Tax on trust property/Value of trust property x 100% = £20,000/£500,000 x 100% = 4%.
Periodic charge (max of 6%) = 30% of the effective rate = 30% x 4% = 1.2%.
IHT payable = Value of trust property x periodic charge = £500,000 x 1.2% = £6,000. |
If capital is distributed then an Exit Charge is levied as a fraction of the effective tax rate based on the time that has elapsed since the commencement of the settlement, or from the date of the last ten-year anniversary.
How may these changes affect you?
Trusts in force prior to 22 March 2006
IIP trusts will continue under the old regime, providing the beneficiaries as at 22 March 2006 are unchanged. The government has provided a window of opportunity to effect a change before 6 April 2008, which will be treated as if it was the position as at 22 March 2006. Should a change be made after this date or a further settlement made to the trust then the new rules will apply. A&M trusts will continue under the old regime provided the trust assets go to a beneficiary absolutely at age 18. Again there is a concession to allow the trust terms to be altered to provide for this before 6 April 2008. The new rules mean that where the beneficiary is entitled to the trust assets by age 25 then the periodic charge will not apply whilst they are under 18. It will apply from age 18 to 25.
Life Policies written in trust
Many protection policies have been written under trust to protect the proceeds from any potential inheritance tax charge. IIP Trusts have been used in this respect and therefore the new rules may affect existing arrangements or new policies written after 22 March 2006. Those policies already written in trust should be exempt from the new rules providing the beneficiaries remain unchanged and there is no new settlement to the existing trust. It is unlikely that varying the terms of a policy in line with the options available under the plan will lead to a change in tax treatment. For any new policy written in trust after 22 March 2006 the payment of premiums should continue to qualify under either the annual exemption or gifts out of excess income. But care must be taken because premiums that do not qualify under these rules could be treated as CLT’s.
| "Many life policies will have a small or nil surrender value so no periodic or exit charge should apply." |
Many life policies will have a small or nil surrender value so no periodic or exit charge should apply. Should the market value of the policy exceed the nil rate band, or if death benefits are paid to the trust prior to and distributed just after, a ten year anniversary, then charges could be levied.
Discounted Gift Trusts
Discounted Gift Trusts, whereby the individual gifts an asset into trust and retains an entitlement to continue to receive an income from the asset, and Gift & Loan Trusts, where an individual makes a small gift into trust and then makes a Loan to the trust, should not be affected providing the beneficiaries aren’t changed. The IHT treatment of Pension-By-Pass Trusts, written on a discretionary basis, also appear to be unaffected.
If you are concerned that the changes might affect you, call our advisers on 020 7189 9990.