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New Rules for Trusts

14 August 2006

The major change for tax-planners arising out of the Chancellor's 2006 Finance Act was to make transfers of assets into most types of trust chargeable to Inheritance Tax.

There are two main categories of trust – those under which one or more beneficiaries have a 'vested interest' – i.e. the right to benefit from the trust; and those which give the trustees the power to decide which of an often broadly-defined group of people should benefit.

Within each of these categories there are two main types of trust. Vested interest trusts can be either Interest in Possession trusts, under which a beneficiary has the right to receive the income from the trust as and when it arises; or Bare trusts, under which the beneficiary has an immediate and absolute right to both income and capital.

The Bare trust is often used by parents wishing to designate property for the benefit of their children, who would be able on reaching the age of 18 to demand that the trust property should be transferred into their own name as absolute owner.

The two main types of trust in which beneficiaries have no vested interest are Discretionary trusts and Accumulation and Maintenance ('A&M') trusts. A&M trusts are a species of Discretionary trust for children, under which the beneficiaries must attain a vested interest by no later than age 25.

Prior to the 2006 Budget, transfers of money or property to all trusts other than Discretionary trusts were classed as Potentially Exempt Transfers. That is to say, they would not incur a charge to Inheritance Tax unless the person who set up the trust died within seven years of doing so.

This situation has now been turned on its head, and transfers to all types of trust other than Bare trusts are classed as chargeable transfers. If the transfer takes place during the lifetime of the 'settlor' of the trust, tax will be charged at 20% and there will be additional 'periodic' charges of 6% at 10-yearly intervals and exit charges when property leaves the trust. If the transfer into trust takes place under the terms of a Will, tax will be charged at the full rate of 40%.

There are, however, a number of exemptions, which have gained in importance now that the tax net has been broadened. The most important of these is the 'nil rate band', currently £285,000. Any transfer of less than this value, whether during the settlor's lifetime or under a Will, will be charged at 0%; and any transfer of a greater value will only be charged on the excess over the nil rate band - though in calculating this figure account will be taken of any other chargeable transfers made within the previous seven years.

The other notable exemptions are the £3,000 annual exemption and the exemption for regular payments out of income (which will usually cover the cost of premiums on any life policy taken out to fund an Inheritance Tax bill on death).

Transfers to Bare trusts are still classed as Potentially Exempt Transfers, as are outright gifts. Unlimited sums may be disposed of in this way, which will escape Inheritance Tax altogether provided that the donor lives for more than seven years after making the transfer. However, it is entirely possible that this window of tax planning opportunity may be closed in a future Budget, in accordance with the Labour Party manifesto.

Another opportunity, which may prove short-lived, is that of Business Property Relief (see overleaf). This provides 100% exemption from Inheritance Tax for investments in fledgling companies which are quoted on the Alternative Investment Market (AiM). However, this is likely to be appropriate only for the more sophisticated investor.

Trusts will continue to have an important role to play in personal financial planning, particularly in situations where the objective is to provide a financial benefit without relinquishing control of assets. The protection of the interests of children following a divorce is a recurring example. However, fewer Interest in Possession and A&M trusts are likely to be set up in future, and benefactors are likely to prefer Bare trusts or Discretionary trusts (which provide greater flexibility than vested interest and A&M trusts and for which the tax rules have not changed).

The attractions of establishing nil rate band Discretionary trusts under Wills remain, and this will continue to be a popular way of saving tax by ensuring that each spouse makes full use of their own nil rate band. However, this has become a complex area and it is vital to take expert professional advice.

There are transitional provisions for existing trusts. The previous rules will continue to apply to IIP trusts until the current beneficial interest comes to an end and there will be no new tax consequences if the property then ceases to be subject to the trust.

A&M trusts will be spared the tax charge if they provide, or their terms are changed before 6 April 2008 to provide, that a beneficiary will receive an absolute interest in capital by the age of 18; but if the previously standard age of entitlement of 25 is retained, an exit charge of 4.2% will be levied. This implicit encouragement to permit young people to benefit at age 18 has been widely criticised on the ground that many are insufficiently responsible at that age to manage their financial affairs sensibly.

We appear to be moving to a situation where every means of avoiding tax is being regarded as a loophole which needs to be blocked. The message must be to make use of existing concessions while they remain available.