20 March 2018
Discretionary trusts, whenever created, and most other forms of lifetime trusts (other than bare trusts and qualifying trusts for disabled persons) established on or after 22 March 2006 are subject to what is known as the ‘relevant property' regime which imposes a charge to IHT on the capital value of the trust assets on each 10 year anniversary of the creation of the trust and ‘exit' charges when capital is distributed or property otherwise ceases to be relevant property.
Over the past couple of years, the Government has been consulting with the stated aim of simplifying this charging regime and at the same time blocking tax planning using multiple trusts. In the end, there is very little in the way of simplification, but there are at least two traps which it is easy for trustees to fall into under the new regime.
First, the good news: for the purpose of calculating charges, each settlement has its own IHT nil rate band (currently £325,000) which is reduced by any chargeable transfers made by the settlor in the seven years prior to establishing the settlement. Generally speaking, if the value of the settled property is within that nil rate band, then there will be no tax charge. The one point of simplification is that under the old rules property in the trust fund which was not relevant property (for example, assets within a life interest fund established prior to 22 March 2006) was taken into account when calculating the rate of charge and this could therefore result in a tax charge on the relevant property, even though that itself was within the nil rate band. For chargeable events taking place on or after the date on which the summer Finance Bill receives Royal Assent, which is expected to be November if not before, the property which has never become relevant property will no longer be taken into account.
Secondly, the widely discussed proposals to allow only one nil rate band to set against the inheritance tax cost arising in multiple settlements has not been taken forward. It will still, therefore, be possible to create settlements of up to the nil rate band (£325,000) every 7 years, with no inheritance tax arising on creation or in the first 10 years.
Now the traps
The charges are on the value of the capital of the trust property; thus income distributions are not subject to an exit charge and also income which is retained (but not accumulated to capital) on the 10 year anniversary is excluded.
Under the rules which applied prior to 6 April 2014, income which was accumulated to capital part way through a 10 year period was treated as ‘added' to the settlement on the date of accumulation. The overall rate of tax on those (and any other capital additions) would be reduced as that capital had not been relevant property throughout the entire 10 year period. Rather surprisingly, HMRC have not changed the general rule regarding added property (even though this makes the calculations complicated where it applies).
However, in relation to 10 year anniversary charges on or after 6 April 2014, income which has been retained in the settlement for five years or more, and not accumulated, will be treated as capital and moreover will be treated as having been comprised in the settlement for the full 10 year period. This means that the full 6% rate of charge will apply to it.
By contrast, it appears to be the case that if the trustees formally resolve to accumulate that income at some point prior to the 10 year anniversary, that income will only be treated as capital from the date of accumulation and the charges will be reduced accordingly. Trustees are therefore advised to review the amounts of retained income in the settlement in good time before the 10 year charge (at least six months to one year before is recommended) and formally to resolve to accumulate income which has arisen during the first five years since the date of the settlement (or the last 10 year anniversary if later).
To take an example, a settlement which will have its next 10 year anniversary on 6 April 2016 has £200,000 of retained income and £100,000 of this arose on or before 5 April 2011. If nothing is done, £100,000 of that income will, on the 10 year anniversary date be taxed at the full rate of 6%: a tax charge of £6,000. By contrast, if the trustees resolve to accumulate that income on 6 April 2015 it will be treated as added to the settlement at that point and the tax charge will be only £600.
A common form of tax planning to secure a number of nil rate bands has been to set up a series of settlements on different days and add property to them on the same day. The Rysaffe case confirmed that this had the effect of giving each settlement a separate nil rate band. The new rules prevent this tax planning exercise where property is settled on or after 10 December 2014, but will also apply to existing settlements where property has been added to them on or after 10 December 2014 (and the relevant property charge arises after 6 April 2015). Any trustees who are therefore aware that the settlement they deal with is part of such a series of settlements should take great care to ensure that there are no additions which could ‘taint' the trust for the purposes of these rules.