updated on 16 May 2006
QuestionThe Chancellor's surprise announcement in his Budget speech of new tax rules for trusts generated a furore in the specialist press and among private client lawyers. What's all the fuss about?
For instance, the beneficiary of a trust may be a minor, who cannot own land or may lack the maturity desirable for dealing with large amounts of cash. Alternatively, a settlor may wish to provide his spouse with the income arising from trust property while leaving the capital for their children.
Additionally, in the United Kingdom, trusts have generally benefited from a comparatively sympathetic inheritance tax (IHT) regime.
However, despite protestations to the contrary, the current government appears to have come to regard trusts primarily as vehicles for tax avoidance. The Chancellor's Budget announcement was deceptively described as aligning the IHT rules for trusts. But the overall effect has been the most significant change to IHT since it was introduced in 1986.
The two types of trust affected are accumulation and maintenance trusts (A&M trusts) and life interest or interest in possession trusts (IIP trusts).
The Pre-Budget Regime
A&M trusts allow the income from the trust property to be accumulated and added to the capital until the beneficiary reaches a certain age, when he must either receive the right to the income or to the capital itself. Different trusts may make different provision as to this age, but it cannot be later than 25.
During the period of the trust, the trustees have a discretion, instead of just accumulating the income, to use it for the education, maintenance or benefit of the beneficiary. Such trusts are often set up to provide for children or grandchildren until they are old enough to have personal control of the property.
Under the pre-budget regime gifts of assets into A&M trusts were exempt from IHT as long as the donor survived seven years from the date of the gift. There was no charge to IHT during the lifetime of the trust or when assets left the trust.
IIP trusts are often set up to provide a beneficiary (the life tenant), often the settlor's husband or wife, with the income from the trust assets during his/her lifetime with the capital passing then to the family's children or grandchildren on the life tenant's death.
Property held in IIP trusts was treated as belonging to the life tenant's estate for inheritance tax purposes. Since transfers of property between spouses are exempt from IHT, this meant that where the life tenant was the settlor's spouse the transfer of assets to the trust would also be exempt. Equally, the same exemption was available if the trust terminated in favour of the settlor's spouse.
Where the life tenant was not the settlor's spouse the tax treatment was the same as for A&M trusts. Gifts into the trust were exempt from IHT as long as the settlor survived more than seven years and there were no IHT charges during the trust period or when assets left the trust.
The Budget Changes
This relatively favourable IHT treatment has now been abolished for both IIP and A&M trusts. With limited exceptions, both will now be taxed in line with trusts in which no person has an interest in possession. The new rules mean that there will be:
Among the exceptions, for which the existing regime will continue to apply, are new trusts created on death for a minor child who will become fully entitled to the trust property at 18 and trusts created either in the settlor's lifetime or on death for a disabled person.
There will be transitional provisions for existing trusts. A&M trusts under which the beneficiaries become fully entitled to the property at 18 will continue to benefit from the pre-Budget regime. This treatment will also apply if an existing A&M trust can be modified to comply with this requirement.
However, there may be practical difficulties about modifying existing A&M trusts to ensure that the pre-Budget regime will still apply. Few A&M trusts currently allow the beneficiaries to become absolutely entitled at 18 and few settlers are likely to see this as desirable.
The pre-Budget rules will continue to apply to existing IIP trusts until the interest in the trust at 22 March 2006 comes to an end (but with some transitional provisions for life interests substituted for this before 6 April 2008). If someone takes absolute ownership of trust property thereafter, this will be treated as a transfer from the life tenant and receive the same IHT as now. If the life interest comes to an end, but the property remains on trust, this will be treated as the creation of new settled property.
What are the Likely Effects?
The Chancellor's announcement was completely unexpected. There was no prior consultation with practitioners and the new rules have potentially serious consequences for trustees and those who already have trusts established in their wills. Individuals in such situations will need to take urgent steps to consult specialist advisers. The use of A&M and life interest trusts generally is likely to decline.
While some have argued that the impact of the new regime may not be as drastic as first suspected, the rules nevertheless represent a dramatic attack on the freedom of individuals to control the way in which their wealth is passed down.
James Hordern is a trainee solicitor in the Private Client Department of
Mills & Reeve's