01 April 2006

Stop Press - Finance Act 2006: inheritance tax and trusts


Judith Ingham
Partner | UK

Introduction

Following the radical changes to inheritance tax announced in the March Budget and enacted in Finance Act 2006, HMRC have just published their response to a number of questions put to them jointly by STEP and CIOT in September.
On the whole, the response includes some very helpful clarification on the new rules which represents, in most cases, welcome news for taxpayers. Whilst some of the responses had been expected, their publication marks an important milestone in laying down the ground rules for estate planning in the UK going forward.

Planning on death – use of main residence

The HMRC responses to questions about will structuring contain some helpful pointers for estate planners.  It seems from HMRC’s replies that, if part of a couple’s main residence is used, on the death of the first to die, to fund a nil rate band trust under which the survivor can benefit then, provided that the terms on which the trustees exercise their power to benefit the survivor are drawn carefully, the survivor can continue to live in the property without bringing it back into his/her estate for inheritance tax purposes.

Planning on death – trusts for children

HMRC have confirmed that gifts in wills of parents which pass capital outright to children as a class if the children survive to 18 or 25 will fall within the preferential rules.  In the case of will trusts passing capital at 18, no ongoing inheritance tax will apply.  For trusts passing capital at 25, the inheritance tax exposure will be limited to the 18-25 window regardless of the age of the children when their parent dies. This is welcome news for families whose current wills feature class gifts of this type which are common in practice.
It is also good to know that favoured trusts for children may be created in relation to the estate of the first parent to die, even if they are created by the exercise of a power in the will of the deceased rather than being written directly into that will.  This means that where wills confer a life interest on a surviving spouse/civil partner and give the trustees an overriding power to defeat that interest or to make appointments which take effect on its termination, the same benefits can be obtained as under a more rigidly drawn will, but with the opportunity to defer deciding which route to take until after the death of the first to die.

Planning on death – immediate post-death interests

HMRC have confirmed that it is possible to create a favoured immediate post-death interest or ‘IPDI’ where the will of a deceased person is cast in discretionary terms and the executors exercise their discretionary powers to create a life interest within 2 years of death.  This is extremely helpful in relation to large or complex estates where it may be preferable to defer the final division of assets until after an individual’s death.

Planning on death – US persons

HMRC were asked about the status of a trust funded when a will simply ‘pours’ the estate over into an existing life interest trust.  They have helpfully confirmed that the interest in the testator’s estate which the life tenant takes by virtue of a combination of the will and the trust will qualify as an immediate post-death interest.  This is very welcome news for the large number of US taxpayers who have estate plans in this form to avoid the expense and complexity of probate formalities in the US.

Existing life interest trusts – transitional period

A number of questions were raised with HMRC seeking clarification as to the scope for taking action to modify life interest trusts in the ‘window of opportunity’ that exists until 6 April 2008. The questions were directed at the circumstances in which new life interests which, during the transitional period, replace existing ones, will count as ‘transitional serial interests’ and thus escape the 6% relevant property regime going forward.
The positive points to note are:-

  • Partial gifts from a life interest fund are permitted.
  • Multiple gifts in favour of more than one beneficiary from the same life interest are permitted.
  • Appointments which ‘extend’ a trust, for example where a beneficiary was due to receive capital outright at age 25, an appointment deferring capital entitlement to age 50 are permitted. (This is welcome news where such extensions are desirable from a ‘divorce/family breakdown protection’ perspective.)

However, traps remain for the unwary and in particular:-

  • There is only one opportunity to take action to create a transitional serial interest before 6 April 2008.
  • Restating existing trusts will use up that single opportunity.
  • Consolidating assets held in different trusts into one trust is not permitted – to qualify under the grandfathering rules assets must remain in the current trusts.

Existing trusts – additions

HMRC have also given some guidance on how they will treat additions to existing settlements made after the Budget with a view to, for example, meeting the trustees’ expenses.  Any extra funds so contributed will be potentially subject to  the 20% up front charge if they are in excess of the taxpayer’s nil rate band and either cannot be categorised as normal expenditure out of income or do not fall within the annual exemption.  However, provided that the amounts contributed are used quickly in meeting expenses, they should not  ‘infect’ the existing trust property.

The position is different where additional funds are used to improve the trust property – in this case, the property will have to be valued before and after the improvements are made so that the proportion of the total value attributable to the amount contributed for the improvements can be treated as within the relevant property regime going forward.

Accumulation and maintenance trusts

HMRC’s guidance on class gifts for children mentioned above in the context of will trusts also applies to existing lifetime trusts.  In particular, it is helpful that an 18-to-25 trust can be created even though the class of beneficiaries remains ‘open’ for future born beneficiaries to benefit.  However, they have confirmed that once a beneficiary has a right to the income under an existing accumulation and maintenance trust, there is no scope for appointing his/her share onto 18-to-25 trust terms. 

It is worth noting that there is a ‘window of opportunity’ for beneficiaries who attain income rights under 18-to-25 trusts at 18, in that funds can be advanced to them outright within three months of them attaining the age of 18 without any inheritance tax exit charge yet with the opportunity to holdover any inherent gain for capital gains tax purposes. 

Normal expenditure claims

There is also welcome news that there is no need for taxpayers who are relying on the normal expenditure out of income exemption to enable them to fund lifetime trusts post the Budget to claim the relief by making a return each time they make a payment.  The need to claim normal expenditure relief therefore only arises on the death of the taxpayer when it is hoped that there will be a good track record of gifts having been made without affecting the taxpayer’s normal lifestyle over a number of years.

Conclusion

HMRC’s responses are, for the most part, very welcome in that they reflect a pragmatic approach to the uncertainties which have inevitably arisen in the context of such fundamental changes to the existing regime.  There are still some outstanding points and it is hoped that these will be clarified when the formal guidance notes are issued.
Taxpayers can now proceed to review their estate planning in the knowledge that the lines of demarcation in the post Finance Act 2006 regime are now largely drawn.

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