The Briefing Note(“BN25”) which accompanied the UK Budget on 22 March 2006 dropped a real bombshell. It proposed the most sweeping changes ...

The Briefing Note(“BN25”) which accompanied the UK Budget on 22 March 2006 dropped a real bombshell. It proposed the most sweeping changes to the Inheritance Tax treatment of trusts that there has been since IHT was introduced in March 1986. Most changes will be effective from 22 March 2006 and so we are already in this new tax regime. The details of the proposed changes are examined below but it is clear that they are an attack on trusts.

Many commentators feel that the changes are politically driven and that they must surely carry a serious political risk to the UK Government in that they look like an attack on “Middle Britain” as the users of trusts.

Her Majesty’s Revenue and Customs has recently undertaken a long and open consultation process to review the income and capital gains regime for trusts and their consultation paper identified the very sensible aim to create “A tax system for trusts that does not provide artificial incentives to set up a trust but, equally, avoid artificial obstacles to using trusts where they would bring significant non-tax benefits”.

The proposals in BN25 entirely ignore this principal. Trusts will be more heavily taxed even if they are established for non-tax reasons.

The changes, as proposed, are likely to mean that many hundreds of thousands, and possibly millions, of wills and trusts will need to be reviewed.

BN25 is sketchy in its detail and raises as many questions as it answers. We will know more of the detailed rules now that the Finance Bill has been. It is thought that there will be many changes to the Bill as it goes through the Parliamentary process, and certainly there will be a lot of lobbying from many professional bodies, such as STEP, the Law Society etc. We are unlikely to know the final outcome until the Finance Act, which is likely to be passed in July.

So now lets move on to look in detail at the proposed changes.

Glossary of Terms
·“Potentially Exempt Transfer”. A lifetime transfer which does not give rise to an immediate liability to IHT and is exempt from IHT if the donor survives it by at least 7 years.
·“Nil Rate Band”. £285,000 from 6 April 2006. The Chancellor has announced that the Nil Rate Band will rise to £300,000 in 2007, £312,000 in 2008 and £325,000 in 2009.
·“IIP Trust”. An Interest in Possession Trust from which someone is entitled to the income as of right.
·“A & M Trust”. A trust made for the provision of young people. The requirement is that a beneficiary or beneficiaries must become entitled to either the income or the capital prior to attaining the age of 25. A & M Trusts tend to be drafted so as to become IIP Trusts on beneficiaries attaining the age of 18 or 25.
·“Discretionary Trust”. A trust in which no-one has an entitlement to income as of right and which is not an A & M Trust.
·“Relevant Property”. Prior to the Budget, this was property held in Discretionary Trusts. Most importantly, the regime provided for:
- an immediate “entry” charge of 20 per cent on lifetime transfers that exceeded the Nil Rate Band
- a “periodic” tax charge of 6 per cent on the value of trust assets over the Nil Rate Band once every 10 years; and
- an “exit” charge when funds ceased to be relevant property between 10 year anniversaries.
- “Holdover Relief”. The ability to defer gains in a transfer of property for capital gains tax purposes.

IHT Regime Prior to Budget Day
A lifetime transfer to an IIP Trust or an A & M Trust was a potentially exempt transfer.
A & M Trusts were not relevant property and so not subject to the periodic tax charge or the exit charge.

Property in IIP Trusts was treated as forming part of the estate of the beneficiary who was entitled to the income as of right. A consequence of this was that if the person entitled to the income as of right was the spouse, widow or widower of the settlor, the transfer to the IIP Trust would qualify for the spouse exemption.

Similarly, if an interest in possession terminated in favour of a spouse, widow or widower, the spouse exemption would be available.

New Lifetime Trusts
With the exception of a trust created for a disabled person, all lifetime transfers to a trust will now be immediately chargeable. This means that if the value of the property transferred to the trust exceeds the nil rate band, the excess will be liable to IHT at 20 per cent. Once in the trust, the property will be liable to periodic and exit charges. In the case of an IIP Trust, the property will no longer form part of the life tenant’s estate.

It would appear, therefore, there will no longer be any benefit in creating IIP Trusts or A & M Trusts since a transfer to a Discretionary Trust will result in the same tax treatment and will provide maximum flexibility.

One consequence of this change is that holdover relief will now be available on most transfers to trusts which are immediately chargeable and also on transfers from such trusts. This is the case whether or not the Nil Rate Band is exceeded.

Existing IIP Trusts
These will continue under the existing regime for the time being.

If, on the termination of the current interest in possession, someone takes absolute ownership, this will be a transfer by the person with the interest in the property. This will either be a transfer on death, or a potentially exempt transfer if they are still living, and so the IHT treatment will be the same as it is now.

If the interest comes to an end so that the property remains in trust, this will be treated as the creation of new settled property. In the case of a lifetime termination, this will be a transfer creating relevant property and will therefore be immediately chargeable. If the interest comes to an end on death it will form part of the deceased’s IHT estate as now, but the settled property will thereafter be relevant property.

This will clearly make restructuring existing trusts much more difficult than was previously the case since, if the value of the property involved exceeds the Nil Rate Band, there will be an immediate liability to Inheritance Tax. In addition, and most significantly, the changes mean that if property is subsequently held in trust for the spouse, widow or widower, the spouse exemption will not be available.

It appears that there may be some kind of transitional period between now and 6 April 2008 although the precise status of this is not clear. It is possible that the result of this transitional period will be to make some reorganisations attractive between now and 6 April 2008.

In the case of trusts where a new interest in possession arises after 22 March 2006, and subject to the transitional rules, such property will be relevant property and so will not benefit from a rebasing for capital gains tax purposes on the death of the life tenant.

Existing A & M Trusts
Where existing A & M trusts provide that property passes to a beneficiary absolutely at 18, or the terms of the trust are altered before 6 April 2008 to provide for this, the current IHT treatment will continue. Few trusts currently provide for this and, in many cases, families will feel that such a modification is undesirable.

Where beneficiaries do not become absolutely entitled at 18 then the trust assets will become relevant property from 6 April 2008 and the periodic and exit charges will apply.

In a number of cases, existing A & M trusts will become IIP trusts prior to 6 April 2008 by virtue of beneficiaries reaching a certain age. It would appear there will be no tax charge on the interest in possession arising but that with effect from 6 April 2008, the property will be relevant property. This means that after that date the property will not be treated as part of the estate of the beneficiary who has the interest in possession.

Efforts are being made to persuade the UK Government to change the relevant age from 18 to 25 which would considerably improve the position. In some cases, however, absolute entitlement at 25 may not be appropriate.

Existing Discretionary Trusts are unaffected.

Wills
Wills which provide for property to pass into someone’s absolute ownership will not be effected by the changes.

The changes will have the greatest effect where they provide for IIP Trusts. If the interest in possession cannot in any way be defeated or overriden, the position will broadly be as it was prior to 22 March 2006. In other words, if the widow or widower of the deceased is the person entitled to the income, the spouse exemption will be available. The property will be treated as part of the life tenant’s estate for IHT purposes as before.

If, however, the life interest is capable of being “replaced” in some way, the property will be treated as relevant property. Most significantly, this will mean that in the case of a will providing for an interest in possession in favour of a widow or widower which is capable of being altered, the spouse exemption will no longer be available. This is potentially very serious and would make such wills unattractive. Individuals should wait until the Finance Bill is published before deciding whether any changes are necessary.

The potential loss of the spouse exemption in such situations will be particularly serious for people in second marriages where there is a wish to make provision for the surviving spouse but to ensure that property ultimately passes to the children of the testator.

For the time being, it looks as if wills should either provide for absolute interests or be fully discretionary. Fully discretionary wills should be capable of being altered within 2 years’ of death so as to secure the spouse exemption if appropriate, or to divert assets to other beneficiaries.

The authors can be contacted at matthew.hansell@mills-reeve.com and justin.ripman@mills-reeve.com