The Chancellor in his Budget announced a number of changes affecting the private client world and in particular the inheritance tax treatment of trusts.
The key points of interest that individuals, trustees and their advisers should be aware of are set out below.
HMRC’s Press Release BN25 is titled ‘Aligning the Inheritance Tax Treatment for Trusts’. A more accurate title would be ‘Penalising Families for Using Trusts to Hold their Assets’.
In December 2003, HMRC announced their approach to the reform of the taxation of trusts was essentially to create a ‘level playing field’ between assets held in trusts and assets held personally by individuals (from Modernising the Tax System for Trusts – overview of the proposals 17 December 2003.)
“4. The Government recognises the important role trusts play in society. As far as possible it wants a tax system for trusts that does not provide artificial incentives to set up a trust but, equally, avoids artificial obstacles to using trusts where they would bring significant non-tax benefits”.
HMRC have spent more than two years consulting with professional bodies in the context of income and capital gains tax where this has been their core message. The measures announced today in relation to inheritance tax completely contradict that stated objective. They unfairly penalise the holding of property through trusts to an extraordinary extent.
Accumulation and Maintenance Trusts (‘A&M Trusts’)
A&M Trusts are special trusts for children/grandchildren which, until today, qualified for special inheritance tax status provided the beneficiaries became entitled to income by the age of 25 at the latest. They have been used to a significant extent by ‘middle England’ as a way for parents and grandparents to fund the needs of their children/grandchildren in a wholly legitimate way for the last 31 years.
From today, except in very limited circumstances, anyone establishing a new A&M Trust will be subject to an inheritance tax charge at 20% on the value of chargeable assets gifted to that trust in excess of the nil rate band (£275,000 at the moment, £285,000 from 6 April 2006) – furthermore, these trusts will be taxed on a ten yearly basis at 6% on the excess value over the nil rate band.
Even more extraordinary, unless existing trusts (ie those established prior to 22 March 2006) are, or are converted by 6 April 2008, into ones where the children concerned receive the property outright at age 18, they will also be subject to the 6% ten yearly charge inheritance tax rule even though these rules had no application at the time the settlement was created.
The inability to make new lifetime trusts for children and grandchildren without a 20% charge on the value in excess of the nil rate band, means that families will be forced either to make outright gifts at a point where the receipt of wealth could seriously deflect children and young adults from their studies, or to make no gifts at all – it is difficult to see what fiscal objective this actually achieves.
Life Interest Trusts
These trusts are commonly used by parents to provide for their adult children. Often the motivation behind parents creating trusts in these circumstances, is to protect family assets in the context of the potential divorce of children and to enable the property to be managed on behalf of the children eg family companies where voting control may need to be kept in a ‘pooled’ vehicle.
Existing life interest trusts will now become subject to the discretionary trust regime when the current life tenant’s interest comes to an end unless, on the death of the existing life tenant, the property passes outright to another individual.
Going forward, life interest trusts established after 22 March 2006 will fall to be taxed under the discretionary trust regime. Funding such a trust will trigger an immediate charge to inheritance tax at 20% unless the terms of the trust fall into certain restrictive categories, as set out for A&M Trusts above.
This seriously restricts the ability of families to undertake careful planning for the gifting of family assets – the current inheritance tax treatment of trusts, other than discretionary trusts, is the same as that applicable to outright gifts and
Adding to Existing Settlements
Care should be taken in relation to any additions to existing settlements as well as the establishment of new settlements, as the new rules will apply equally to both.
One immediate problem area which springs to mind is in the context of divorce settlements where one spouse may be required to settle property on to trust for a former spouse for a fixed period until children obtain a specified age. We have some initial concerns that this type of arrangement, which is currently tax neutral, might fall foul of the new rules.
Implications for Will Planning
The changes could have important implications for will planning – it would seem that multi-generational trusts and those with flexible overriding powers could be treated unfavourably and that choices may need to be made between accepting the discretionary regime with 10 yearly charges at 6% or outright gifts unless property continues to qualify for 100% relief from inheritance tax as business or agricultural property.
With no consultation whatsoever, the existing rules on the inheritance tax treatment of trusts have been turned upside down and the current beneficial regime afforded to all but discretionary trusts, will be limited going forward to a very narrow category of trusts for the disabled or trusts where children receive property outright at age 18.
The changes provide substantial disincentives for families to create trusts as holding vehicles for assets except in relation to property which qualifies for 100% relief from inheritance tax. They are ill thought through and constitute an attack on the use of trusts as an accepted planning tool which completely contradicts HMRC’s previous acceptance of trusts as a legitimate holding vehicle for assets.
We will need to await the publication of the Finance Bill 2006 to assess more fully the detailed implications of these changes. It is anticipated that STEP and other professional bodies will undertake some vigorous lobbying in order to modify some of the more unfair consequences of the proposed changes.