The Budget and Finance Act changes to the inheritance tax treatment of trusts are both important and complex. This article attempts to explain them
In a giant Finance Act (which received royal assent on 19 July 2006) there is no doubt of the part which is of greatest relevance to Scottish solicitors. The deceptively brief s 156 introduces the changes made by schedule 20. These changes were of such importance that the original version, which was tucked away in a Budget press release, was dealt with in an “emergency” article in Journal, May, 22-23.
A particular reason for the urgency was that the bulk of the changes took effect from Budget day, 22 March 2006. In that article, it was noted that strenuous efforts were being made by a wide range of professional bodies, including the Law Society of Scotland, to reverse, restrict or delay these changes. That effort involved numerous meetings with HM Revenue & Customs and extensive lobbying of MPs and others. It also involved what might be perceived as the somewhat anomalous argument that the changes, if implemented without modification, would lead to the need for vast numbers of clients to revise their wills. This would of course have cost implications for the clients. It must have been difficult for the government to believe that lawyers (among others) were arguing against changes that would almost certainly have generated more work for them – but that really was the case.
Evidently, but only eventually, some of the professional arguments were accepted by the government. A range of amendments were brought forward late in the standing committee debates, and a few more at report stage. These followed rejection of more extensive opposition amendments which really would have restricted the effects of the overall package. The result received extensive press coverage (as indeed has been the case with the whole dispute). It was said that the government had climbed down, or backed down, or engaged in that old favourite manoeuvre, a U-turn. If only…!
Just more complicated
Most of what appears in the “emergency” article remains applicable. It is still the case that the amendments in this year’s Finance Act represent the most fundamental change in inheritance tax (“IHT”) for 20 years, when (in 1986) potentially exempt transfers were introduced, and rules on gifts with reservation were (at least for those with long memories) reintroduced. It is still the case that the new rules represent a radical departure from any notion that transfers utilising trusts and transfers of outright ownership should be treated neutrally, as far as IHT is concerned. And it is depressingly still the case – indeed, even more so than under the original Finance Bill – that the new rules add immensely to the complications of the system in a great many cases.
The bill contained 18 pages on the subject. By royal assent, this had grown to 33 pages, primarily amendments to the Inheritance Tax Act 1984 (“IHTA”), but with a smattering of related changes in relation to capital gains.
Whether the elements of relief included in the extra verbiage are worth it is debatable. But it is certain that advising the increasing numbers of clients whose family wealth means that they are potentially affected by IHT has become more difficult. It is fair to say that the range of choices may have broadened – different considerations may be appropriate for clients for whom tax saving is paramount, for those for whom it is relevant but less important than other factors, such as control, and those for whom tax is not relevant at all, whether because their estates fall below the IHT threshold or because other factors take precedence. As will be seen, there is a range of new types of trust to be considered in appropriate circumstances.
New transfers to lifetime trusts
The changes made to trusts created or augmented by lifetime transfers have not actually received much publicity, but are among the most important developments. The result is that almost all lifetime transfers to trusts will be treated as immediately chargeable transfers; and a charge to inheritance tax at 20% will arise on occasions where the donor has exhausted the nil-rate band. Thus transfers into liferent trusts are no longer treated as potentially exempt transfers; and transfers where the liferenter is the spouse or civil partner of the transferor are no longer immediately exempt. Lifetime transfers into accumulation and maintenance trusts, whether in “traditional” form or in the new, partially favourable forms created by the new Act, are no longer potentially exempt.
There are exceptions – charitable transfers into trust will continue to be exempt. A late amendment extended the special treatment available to disabled persons’ trusts to a new category, “Self-settlement by person with condition expected to lead to disability” (see IHTA s 89A, inserted by Finance Act 2006, schedule 20, para 6). This very restricted new category merely serves to emphasise that other self-settlement into a trust with a liferent for oneself – previously a complete non-event for inheritance tax purposes – will now involve a chargeable transfer. This will not however be the case with a bare trust for oneself.
Transfers into “true” disabled trusts, set up so as to comply with IHTA s 89, will continue to qualify as potentially exempt. (Disabled persons’ trusts are set up as discretionary trusts, but are treated for IHT purposes as if a (pre-Budget) liferent subsisted in the trust property. The advantages of such treatment may be limited in tax terms. There are various amendments made to the rules for such trusts, which are tied to the beneficiary’s eligibility for certain social security benefits.)
In addition to chargeable transfers arising on the creation or augmentation of lifetime trusts, they will now in almost all cases be subject to the possibility of periodic charges every 10 years; and exit charges when property leaves the trust, whether on the termination of the liferent or otherwise. This replaces the treatment whereby property subject to a liferent was generally aggregated with the liferenter’s own estate on such terminations. Such “exit charges” may be less than the charges which would arise with aggregation, but this is unlikely to be any compensation for charges on the lifetime creation of or addition to such a trust.
New trusts created on death
Although the most fundamental changes probably relate to the lifetime creation of trusts, the most complex series of changes relate to trusts created by wills. Essentially, a number of new categories of trust are created, which have limited tax privileges (or are, at least, not treated as if they were full discretionary trusts under the old regime).
(a) Trusts for bereaved minors
These are the very limited replacements for tax-privileged accumulation and maintenance trusts. The rules, which will be found in a new s 71A of IHTA, have been slightly relaxed since the Finance Bill was originally published. Such trusts must be established by will (or under the Criminal Injuries Compensation Scheme); and that will must be of the parent of the beneficiary (thus such trusts for grandchildren will not be permissible). However, “parent” is extended to include step-relationships.
The conditions start badly for Scotland, with a reference to the English intestacy trusts which arise under the Administration of Estates Act 1925. Such trusts for intestate beneficiaries could only be created by deed of variation in Scotland.
They continue with a requirement that the beneficiary must take the trust property (including any accumulated income) outright, at or before age 18. The beneficiary could be given a liferent before that date; and advances can be made. If these conditions are met, there is no charge as and when the beneficiary takes the trust property outright, or dies under the age of 18; and no periodic charges during the currency of this trust. If the trust fails to meet these conditions, there are special charging provisions attached, similar to those which currently exist for failed accumulation and maintenance trusts.
(b) Age 18-to-25 trusts
These represent the government’s limited response to protests about the need to pass trust property outright to children at age 18. IHTA s 71D creates a new category of trust that can be created under the will of a parent of a bereaved minor. It can be a continuation of a trust for a bereaved minor and there is no charge on the move between the two different types of trust. The prime condition is that the beneficiary must take outright at or before age 25 – before that date they can (but need not) have a liferent interest. There must be no power to exercise discretion between different beneficiaries.
If the conditions are met, the result is that when property comes out of such a trust, it is potentially liable to a charge – an “exit charge” under the regime that was formerly restricted to full discretionary trusts, but based on a different “start date” than that which would normally be the case. The maximum rate of such a charge would be 4.2%, if the property was held in trust until the beneficiary attained 25. There are complex rules for establishing the rate chargeable where there is a chargeable event outwith the rules in s 71D.
(c) Immediate post-death interests
The government attack on basic liferent trusts was always one of the mysteries of this whole episode. Under the old rules, property in which there was an interest in possession was simply aggregated with the estate of the holder of that interest. There seemed to be little possibility of avoidance in such rules, and indeed in certain circumstances a large charge could arise which might not have arisen but for the existence of the interest in possession. But the basic premise of the new rules is that interest in possession (liferent) trusts are to be treated in the same way as discretionary trusts.
There are fundamental alterations made to the basic rule whereby a person’s estate is deemed to include property in which he has an interest in possession (see IHTA s 5, as amended by FA 2006, schedule 20, para 10).
There are also alterations to the rules on situations where property subject to an interest in possession reverts to the settlor or his spouse, heavily restricting what was previously a useful exemption from IHT.
There are however more extensive exceptions (many of them transitional) to this basic premise than exist with accumulation and maintenance trusts and their successors. Under these exceptions, property subject to an interest in possession will continue to be aggregated with the estate of the holder of it; and terminations or transfers from it will be treated accordingly.
The most important is the immediate post-death interest, details of which can be found in IHTA s 49A. As the name implies, this comes into existence after the death of a person and in Scotland must be under a will (or deed of variation). In other parts of the UK, statutory interests in possession can arise on intestacy.
The conditions for such an interest were under the original bill demanding and complicated, both in relation to control over the property in trust and the termination of the interest, and what was required to happen when the interest in possession came to an end. These conditions have now been greatly simplified so that virtually all post-death interests in possession will qualify as immediate post-death interests (unless the will establishes a trust for a bereaved minor, which could have an interest in possession within it, or a disabled trust). Thus liferenters who acquire their rights as such on the death of the testator will continue to have their liferented estate aggregated with their personal estate.
The termination of such an interest (in whole or in part) will continue to be treated as a potentially exempt transfer, where the trust property goes outright to an individual, to a disabled trust or to a trust for a bereaved minor. A range of special conditions are laid down for the last possibility (IHTA s 3A(3B), inserted by FA 2006, schedule 20, para 9(5)).
At least as importantly, this means that liferents in favour of a spouse or civil partner (whatever the terms on which such liferents are to terminate) will continue to attract exemption from IHT on the testator’s death. This was thought to be at serious risk under the original proposals.
(a) Accumulation and maintenance trusts
Existing accumulation and maintenance trusts (that is in relation to trust property in which there is not yet an interest in possession) have only very limited transitional reliefs. If they come to an end, or an interest in possession arises, before 6 April 2008, then the normal accumulation and maintenance trust rules would mean that no charge will arise. However, if the property remains in trust, with an interest in possession in place, what was formerly the discretionary trust regime will now apply in the future.
If however the trust would have continued to be treated as an accumulation and maintenance trust on or after 6 April 2008 under the old rules, it will cease to do so from that date. If it is possible to do so in terms of the trust, it can however be converted by that date. It will continue to qualify as an accumulation and maintenance trust if the beneficiaries must take the trust property outright by age 18.
There is an alternative, in that it can be converted so that when the beneficiary becomes 18, it can continue as an “age 18-to-25 trust”, on the conditions set out above and with the charges associated with such a trust.
(b) Pre-Budget liferent trusts
Where a liferent was in existence before the Budget, it will continue to be treated in the same way as applied before the changes. Thus aggregation will apply and the termination of such a liferent may qualify as a potentially exempt transfer if it takes place during the liferenter’s lifetime. This will apply if the property passes outright, rather than remaining in trust (although see the next section).
(c) Transitional serial interests
There are a number of different forms of transitional serial interest, now to be found in inserted ss 49B–49E of IHTA.
The first is a basic one. It requires there to have been a liferent interest as at 22 March 2006. This must come to an end before 6 April 2008, at which point some other person must have become entitled to the liferent interest. The trust must not be one for a bereaved minor or a disabled trust. The termination before 6 April 2008 will receive pre-Budget treatment, including the availability of any exemptions which may be applicable (such as for spouses); and treatment as a potentially exempt transfer. On a future termination of the interest, aggregation treatment will be available.
The second type of transitional serial interest was added during the passage of the Finance Bill. Again, there must have been a liferent interest prior to 22 March 2006. This must come to an end after 5 April 2008, on the death of the holder in existence as at 22 March 2006. At this point it must pass to the spouse or civil partner of the original holder. In this situation, the spouse exemption will be available on the transfer of the interest, despite the fact that this will be a situation in which a liferent is established other than under the will of the person making the deemed transfer; and the interest will continue to be treated as leading to aggregation of the trust property with the liferenter’s own estate.
The third type relates specifically to life insurance. Policies are often held in interest in possession trusts. As long as changes in the holders of these interests take place on the deaths of the current holder, there are provisions allowing all subsequent holders of an interest in possession in such policy trusts to be treated under the same rules as applied before the Budget.
There are additional amendments made to the rules for life policy trusts, protecting their pre-Budget position where further normal premiums are paid, and dealing with the situation where such policies are held in accumulation and maintenance trusts. In the latter case, decisions may require to be made in relation to such policy trusts before 6 April 2008, as with other such accumulation and maintenance trusts.
IHT – other trust matters
There are a number of other changes to the IHT treatment of trusts consequent on the above. Alterations are made to the definitions of “relevant property”, which make it clear that trust property in which there is an interest in possession which does not fall within the special or transitional rules will be subject to the periodic and exit charges which previously applied only to “full” discretionary trusts. There are some changes to the rules affecting the relatively rare situation where companies hold interests in possession.
Among the more important changes made late in the Finance Bill process were to IHTA s 144. Much of the protest over the proposed new rules was directed at the supposed need for millions of clients to alter their wills. At least some of such changes will be unnecessary under the revised rules; and in relation to others it will be possible to make necessary or desirable changes after the death, under the rules on deeds of variation and similar post-death arrangements. Given that the legislative changes primarily relate to trusts created on death, in fact the basic post-death variation provision (IHTA s 142) may have been of little use. The provision of significance in this context is likely to be s 144, which deals with distributions from property put into trust by will. Alterations are made to this section, to make it clear that (for instance) immediate post-death interests and trusts for bereaved minors can be created out of will trusts. Such creations will be treated as if contained in the deceased’s will from the outset.
Certain changes are made to the rules on conditional exemption, to take account of the primary changes to the IHT rules on trusts.
Finally on IHT, there was in addition an entirely separate change, of a more specific anti-avoidance nature. This relates to the interaction of the rules on the termination of interests in possession with those on gifts with reservation. Before this change, it was possible for an interest in possession to be terminated and for the previous holder of that interest to continue to have the opportunity (and indeed the actuality) of benefiting from the property in question. It was not treated as a gift by the liferenter, and hence could not be a gift with reservation. This has now been changed by the introduction of Finance Act 1986, s 102ZA which treats such a termination as a gift by the liferenter. A reservation could now arise in what is termed in a fresh statutory abuse of the language, “the no-longer-possessed property”.
Consequential changes – CGT
There are two important sets of changes to capital gains tax consequent on the IHT changes.
The first is in relation to the tax-free uplift on death deriving from Taxation of Chargeable Gains Act (TCGA) 1992, s 72, which applies to liferented property on the death of the liferenter. That will now be restricted to pre-Budget liferents, immediate post-death interests, transitional serial interests, disabled persons’ interests and interests under trusts for bereaved minors.
The second change is in relation to the availability of hold-over relief. Without the need for any change in the legislation, there will be more occasions on which an IHT charge (even at 0%) will arise, and which will thus be eligible for hold-over relief under TCGA 1992, s 260. Finally, there is an extension of the situations where the hold-over relief is available despite there being no IHT charge, in certain circumstances where property emerges from a trust for a bereaved minor or an age 18-to-25 trust.
As can readily be seen, life (and death) in the world of trusts have become more difficult and interesting, a process which may not have come to an end. The goalposts remain in a state of perpetual motion.
Alan R Barr, Brodies LLP and the University of Edinburgh