The bare necessities for minor beneficiaries

hm Revenue & Customs has suggested an absolute trust for a minor beneficiary is not a bare trust and may not be a potentially exempt transfer

Question: When is a bare trust not a bare trust? Answer: According to HM Revenue & Customs (HMRC), when it is a trust for a minor beneficiary.

Schedule 20 to the Finance Act 2006 made significant changes to the inheritance tax (IHT) treatment of interest in possession and accumulation and maintenance settlements.

However, the new rules do not apply to bare trusts, that is trusts that are inflexible and where the beneficiaries have an absolute interest that cannot be taken away. This means a gift to a bare trust is still a potentially exempt transfer (Pet) and not a chargeable lifetime transfer. No IHT is payable when a gift to a bare trust is made (no matter what amount) and it becomes fully exempt if the donor survives for a further seven years.

While an absolute trust for an adult beneficiary is a bare trust, the position in respect of minor beneficiaries - those in England and Wales under the age of 18 and unmarried - is less clear.

The term 'bare trust' has various meanings but for the purposes of this article it means a trust that is not a 'settlement' for IHT reasons.

HMRC has recently suggested that, in its view, an absolute trust for a minor beneficiary should be treated as a settlement rather than a bare trust. It is understood the difference in opinion between the market and the Revenue concerns the definition of the term 'accumulate'.

There are two pieces of legislation that deal with the question of the accumulation of income: Section 31(2) Trustee Act 1925 and Section 43(2)(b) IHTA 1984.

The first directs trustees to accumulate any surplus income, while the latter defines a settlement as including the situation where property is "held by trustees on trust to accumulate the whole or part of any income of the property".

While it may seem like splitting the proverbial hair, it appears that what lies at the heart of the argument is the fine distinction between retaining excess income rather than actually accumulating it.

Curiously and according to its own manuals, HMRC accepts that a bare trust to which Section 31 Trustee Act 1925 applies is taxed as a bare trust and not as a discretionary trust for income tax purposes. And while the same logic would appear to apply to capital gains tax, in HMRC's opinion it falls down when it comes to IHT.

Although this matter is currently the subject of further discussion, if its view persists then the transfer of monies into an absolute trust for a minor will not be a Pet, it will be a chargeable lifetime transfer and subject to the new rules.

Until final confirmation is received from HMRC, advisers will need to consider the advice that needs to be given to their customers thinking about using a bare trust.

Of course, even assuming a bare trust results in a Pet, rather than a chargeable lifetime transfer, there is always the perceived problem of children of a relatively young age (18) suddenly having access to what may prove to be a substantial sum of money.

It has been suggested that one possible course of action to overcome this problem would be for a benefactor to invest in a single premium investment bond, which has been endorsed such that it can be assigned only once (by the benefactor to the intended beneficiary) and neither surrendered nor any part-surrenders taken until a point in the future that coincides with the intended beneficiary's, say, 30th birthday.

It seems likely this strategy would succeed in enabling a parent, for example, to make provision for his unmarried minor child, take advantage of the Pet regime and prevent the child from actually getting his hands on the money until a later date.

However, it should be borne in mind that since the bond is an asset that the adult child may well be able to borrow against, thereby defeating the object of the exercise, it may prove to be just one of those clever ideas with no practical use.