Steering the IHT ship

In the wake of the huge controversy caused by the Government's treatment of inheritance tax planning tools in the 2006 Budget and subsequent Finance Bill we asked two leading experts for their views on the changes

The Chancellor's unexpected Budget day announcements regarding the inheritance tax (IHT) treatment of trusts caused confusion and concern. The Finance Bill provided some clarification but uncertainty remains and further changes may precede enactment.

The proposals include sufficient guidance to enable advisers with 'pipeline' lump sum cases to proceed cautiously. Providers are using a disclaimer, stating clients are aware of the Budget implications and wish to proceed. Advisers must explain the position to clients, preferably in writing, before relying on such a disclaimer.

There is also enough information to advise on new cases, although the possible introduction of potentially exempt transfer (PET) treatment of lump sums using absolute trusts may be best delayed.

Most trusts created prior to Budget Day are unaffected by these proposals, but adding funds to a pre-Budget trust will introduce the new rules to the whole trust. This should exclude continued premiums to regular premium policies but the position is unclear where premiums are increased.

Exercising the 'power of appointment' - changing the interest in a flexible trust - will introduce the new rules; trustees have a transitional period up to 5 April 2008 to make appointments under pre-Budget rules. After that, such appointments will (a) be chargeable transfers by the original beneficiary and (b) bring the trust within the new rules.

This is important since its effect is retrospective, despite HMRC assurances.

Some flexible trusts were established with beneficiaries expressed as 'our children whenever born'. A new child would reduce the original child's share (a chargeable transfer by that child) as well as introducing the new rules. While this is absurd, it may be that such trusts should be amended during the transition period and new trusts used for additional children. A further problem is that the beneficiary whose interest is reduced will have to report the chargeable transfer to HMRC (on form IHT100) if the transfer (cash value of the policy, etc) exceeds £10,000 (cumulative in the year) or brings their total of chargeable transfers in a 10-year period to £40,000 or more. This applies even to transfers within the nil-rate band.

Large regular premiums under post-Budget trusts will also need to be reported.Pre-Budget Accumulation and Maintenance trusts will be caught and become 'Relevant Property' Trusts (RPTs) unless amended (before 6 April 2008), so that beneficiaries become absolutely entitled to the trust assets by age 18.

The term 'Interest in Possession' (IIP) in IHT planning has been the main factor in determining whether a payment into a trust qualifies for PET treatment. This is no longer the case. The general definition of IIP, giving an individual 'the present right to enjoyment of trust property' or 'the right to income' has not changed but the IHT treatment has changed radically. Creation of an IIP does not determine whether payments to it are PETs. All types of trust may now be treated as RPTs if created or amended post-Budget unless specifically exempted. A further important change is how a beneficiary's IIP is treated.

Under IHTA 1984, the beneficiary of an IIP is treated as owning the capital supporting that interest. The capital is part of their estate on death and the transfer of an IIP during lifetime is treated as a PET by the original beneficiary. The Finance Bill ends this treatment for IIPs coming into force on or after the Budget except for:

(i) An immediate post-death interest (IPDI) - (Paragraph 5, Schedule 20 Finance (No 2) Bill 2006).

(ii) A disabled person's interest.

(iii) A transitional serial interest (TSI) (Paragraph 5, Schedule 20 Finance (No 2) Bill 2006.

Apart from these trust interests and absolute trusts, a charge to IHT will arise on creation of the trust, ten-year anniversaries and the payment of capital from the trust. The death of an IIP beneficiary under a Post-Budget trust will not result in tax unless assets leave the trust. Here, the assets will be taxed under the trust rules and not as part of the deceased's estate.

Trusts created during a settlor's lifetime post-Budget, except for trusts for the disabled, pension trusts and absolute trusts, will be RPTs. Effectively, this brings virtually all trusts into line with discretionary trusts.

(a) Creation of the trust: This is straightforward. The nil-rate band threshold is £285,000 and only if the total of an individual's chargeable transfers, including any in the previous seven years, exceeds this threshold will an IHT charge arise. If it does, it will be 20%.

If the settlor dies within seven years of the chargeable lifetime transfer it will be added back into their estate (like PETs) and additional tax may be payable, with a credit for any lifetime tax paid; taper relief is also available.

If the settlor uses a discounted gift scheme, the chargeable transfer is the discounted amount. Clients should follow the 'full underwriting' route when discounts are calculated, enabling the most accurate figure possible to be declared on the IHT100.

We believe the use of discounted gift schemes can continue since we can advise on the tax position. Confusion remains over valuing the periodic charge but a 'worst case' position can be given. It may be worth delaying such schemes until absolute trusts can be used with them. Loss of flexibility may be insignificant in comparison to potential IHT benefits.

(b) Periodic charge: There is now only one band and only one rate of tax for lifetime transfers (20%) and death transfers (40%) so the calculation could be summarised as '6% of everything over the nil rate band available to the trust'.

(c) Exit charges: The exit charge is based upon the tax charge at the last 10-year anniversary or, if the charge is incurred in the first 10 years, the tax rate when the settlement was created (or when the trust became an RPT).

A lower rate of tax applies to assets leaving the trust soon after another charge (entry/anniversary). This is provided by applying 1/40th of the tax rate calculated for the previous charge for each complete three month period since then.

David Ingram is a partner at threesixty

trust changes come into focus, writes zurich's Paul Wright

The March Budget delivered a significant blow to some much relied upon inheritance tax planning tools and left the industry reeling. So how exactly have the taxation of Interest in Possession (IIP) trusts and Accumulation and Maintenance (A&M) trusts been affected by the Chancellor's shock move?

Until Budget day, gifts into these types of trusts were classed as potentially exempt transfers (PETs) for inheritance tax (IHT) purposes. Gifts into these types of trusts established on or after Budget day are now classed as chargeable lifetime transfers (CLTs). In understanding why pre-Budget trusts were PETs it is worth going back to basics.

How IIP Trusts were taxed differently PRIOR to the Budget The typical industry IIP trust had a fairly comprehensive list of who could potentially benefit from the trust's assets. Typically this list would have specified categories of 'potential beneficiaries', rather than named individuals - for example, spouse, children, grandchildren, brothers and sisters. The trust form would have also had a blank box, where the settlor would specify who they wanted to have the interest in possession. For simplicity, let us call these the 'current beneficiaries'.

If a settlor made a transfer of value - for example, an investment bond - into an IIP trust it was classed as a PET which remained in their estate for IHT purposes for seven years. However, as the settlor no longer owned the asset, who did?

The answer to this is easy enough. Although it was possible to appoint benefits to the 'potential beneficiaries', as they were not named, without an appointment, ownership of the trust's assets did not belong to them. Conversely the 'current beneficiaries' were actually named. While the 'current beneficiaries' had no automatic right to the trust capital (only to its income), it was deemed to belong to them from an IHT perspective. So, they would have been assessed for IHT on their share of the trust if they died. If their beneficial interest was transferred to another beneficiary - which meant it then formed part of the new beneficiary's estate - for IHT purposes, the cycle started all over again - that is, the transfer was classed as a PET and remained in the outgoing beneficiary's estate for seven years for IHT purposes.

How A&M Trusts were taxed differently Prior to the Budget A&M trusts were usually set up for common grandchildren of common grandparents. While these trusts would have had, typically, at least one child named at outset, others yet to be born would have fallen under the un-named category of beneficiary - for example, grandchildren. However, as A&M trusts had to give an interest in possession to the beneficiaries when attaining a certain age - typically 18 or 25 - the ownership of the trust's assets would be evident within a maximum time period.

In summary, it has always been possible to understand who owns the assets, from an IHT perspective, in IIP and A&M trusts. Therefore, collecting any tax was simply a waiting game for the Revenue, and arguably why they survived in a PET environment for as long as they did.

Why Discretionary Trusts are taxed as CLTs? Discretionary trusts have typically been used for generation jumping. For example, if a third generation of potential beneficiaries - great grandchildren - inherit the trust's assets, IHT is saved on the estate of the previous two. The difference in taxation lies in the fact that there is no interest in possession at outset and neither is one imposed by a certain age. This means the trust can run for its full perpetuity period, usually 80 years, without its assets being attributable to an individual's estate for IHT purposes.

For this reason, gifts into Discretionary trusts that are above the prevailing nil rate band (taking account of any other CLTs made by the settlor in the last seven years), are taxed at half the death rate, currently 20% (50% of 40%), when they are established. The trust also pays a periodic charge every 10 years, on any assets valued above, the then nil rate band. This tax charge is at 30% of the lifetime rate, currently 6% (30% of 20%). In addition, there is an exit charge, if an appointment of capital is distributed to a beneficiary of the trust. This is a maximum of 6% and based on: the marginal rate of tax the trust paid when it was set up (or at the last periodic charge date) and the time elapsed since this date.

New IIP and A&M trusts established after the budget will now be taxed like Discretionary trusts, as described above.

Information released after the budget, and the subsequent Finance Bill, has not fully clarified the position. A fuller understanding of how existing IIP and A&M trusts will be taxed is likely to be clearer after The Finance Act becomes law in July. However, it would appear so far that pre-Budget trusts will be caught by the new rules if a beneficiary's share of the trust is changed after 5 April 2008, or the trust receives any further gifts. It is still unclear how regular premium life policies with contractual increases, such as indexation, will be treated.

These changes, without any doubt, will affect the trust recommendations advisers make to their clients. It is also highly likely to drive a change in the trust proposition that life companies offer. Watch this space.

Paul Wright is investment managing director at Zurich