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Getting things in proportion

Last week, I looked at the 10-year anniversary charge on relevant property held in discretionary trusts and this week it is the turn of the proportionate or exit charge.

You will recall that the context for all this is a review of the inheritance tax consequences of flexible interest in possession and discretionary trusts used in nil-rate band planning, usually, but not necessarily, in connection with an investment bond or a collective investment.

A proportionate charge can arise where the property in a settlement ceases to be relevant property. The main examples are:

  • When the settlement comes to an end.
  • When some of the property is distributed to beneficiaries.
  • When an individual becomes beneficially entitled to an interest in possession in the settled property.
  • When the property is appointed on special trusts, for example, accumulation and maintenance trusts.
  • When the property becomes excluded property.

The proportionate charge is based on the amount by which the value of the rele- vant property in the trust is diminished as a result of the event giving rise to the charge, that is, the loss to the trust.

The rate of the proportionate charge between 10-year anniversaries is a fraction of the rate that was charged at the last 10-year anniversary. This rate is 30 per cent of one-half of the death rate of tax that would apply to a hypothetical chargeable transfer. The fraction is calculated as one-40th for each complete period of three months that has elapsed since that anniversary, so it increases as a 10-year anniversary is approached.

If general rates of tax have decreased since the time of the charge at the last 10-year anniversary, the current lower rates must be used to recalculate the tax charge and, thus, the rate. There are special rules applying when the exit takes place before the first 10-year anniversary and I examine these later in this article.

Let us look at an example to put some flesh on the bones. At the last 10-year anniversary of a settlement, tax of 2,999.50 was charged on the 350,000 relevant property in the settlement, based on a tax rate of 0.857 per cent. Four years (that is 16 quarters) later, 20,000 is distributed to a beneficiary.

Assuming there have been no changes in the general rates of tax since the last 10-yearly charge, the 20,000 will be taxed at the fraction of 16/40 of the rate of 0.857 per cent, so that 68.56 will be payable.

As stated above, special rules apply where the proportionate charge falls due before the first 10-year anniversary of a settlement set up after March 26, 1974. In this case, the tax rate is a fraction of a rate calculated by reference to the value of all the property in the settlement at the time of its creation together with the value of any other property in any settlement made by the settlor on the same day.

The cumulative total of the settlor’s chargeable transfers in the seven years before the setting up of the settlement is also brought into the calculation. This rate is established in much the same way as the rate of the 10-yearly charge.

Say the discretionary trust is that described above. It was established by the transfer of a collective or a bond on the death of the settlor. The value of the trust property when the trust was established was 250,000. Eight years on, the trust property is worth 320,000. This exceeds the value of the nil-rate band now current.

The trustees decide to distribute the whole of the trust property to the beneficiaries. Because the exit is within the first 10 years of the trust’s life and because the value of the trust property when the trust was established was less than the nil-rate band (the settlor having made no chargeable transfers in the seven years preceding the establishment of the settlement and no property having been added), there will be no tax charge.

As can be seen, provided that the initial value of the property transferred to the discretionary trust is at or below the nil-rate band (and assuming that there are no other amounts to take into account in determining the rate), then it will be possible to continue the trust in discretionary format until just before the first 10-year anniversary and make a decision regarding who is to then benefit without a proportionate charge – regardless of the value of the trust property at that time.

So, after all that, when deciding on whether to use a discretionary or interest in possession trust to use an investor’s nil-rate band on death, what are some of the main factors to consider?

There are tax and non-tax issues to take into account. Consider the following:

If the investor wishes there to be a beneficiary who is entitled to trust income, then a flexible interest in possession trust is probably best.

If the value of trust property is likely to exceed the nil-rate band in the future and the investor does not wish there to be any 10-year or exit charges, then a flexible interest in possession trust trust is likely to be preferable.

It should, however, be borne in mind that if a discretionary trust is chosen and, before the first 10-year anniversary, the trust property ceases to be relevant property (that is, subject to a discretionary trust), either by virtue of an appointment of benefits to a beneficiary or by an appointment of an interest in possession, the exit charge will be based on the value of the trust property when the trust was established.

If the combined value of the property made subject to trust and transfers made by the settlor in the seven years preceding the establishment of the trust and any added property do not exceed the nil-rate band, no tax charge will arise.

If the settlor/testator is uncertain as to who he wishes to benefit, then a discretionary trust may be appropriate.

If the settlor/trustees envisage frequent changes of mind as to who should benefit from the trust income or capital, then a discretionary trust may be most appropriate.

The above represents some but by no means all of the key determinants. The answers given may indicate a conflict between whether a fully discretionary or flexible interest in possession trust is most appropriate.

In this case, it will be necessary to weigh the importance of the competing factors to make the right choice in any particular case. It is here that the value of advice can seen most clearly.

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