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Happy anniversary

Now it gets interesting. This week, I am going to look at the inheritance tax treatment of discretionary trusts.

Any adviser recommending discretionary trusts to his or her clients for use in nil-rate band planning should be aware of the IHT conseq- uences. I am not saying you need to be an expert but you do need to be familiar with the main points.

At some time, the client will die and the trusts incorporated into his or her will – or the post-death trusts incorporated into a lifetime trust, in which the settlor will have had an initial interest in possession – will become operative. The IHT consequences of the trusts will then need to be understood.

Perhaps more important, these consequences should be understood at the point of recommending the trusts so as to give informed guidance on the type of trusts that could be most appropriate.

Property held in discretionary trusts is called relevant property. There are two types of charge on relevant property. The first is an anniversary or periodic charge every 10 years, called the 10-yearly charge, and the second is a proportionate or exit charge when the property or part of it ceases to be held in a discretionary trust.

I will look first at the 10-yearly charge. This is made 10 years after the creation of the settlement and at the end of each subsequent 10-year period during the life of the settlement.

The amount charged to tax at each 10-year anniversary is the value – after any business property or agricultural property relief – of any relevant property in the settlement immediately before that anniversary.

There are special rules for settlements created before March 27, 1974, which I will not cover here. For trusts set up after March 26, 1974, under section 66 IHTA 1984, the rate at which the 10-yearly charge is imposed is 30 per cent of the rate which would be charged on a hypothetical chargeable lifetime transfer. That rate is half of the death rate, currently 20 per cent.

The amount on which tax is assumed to be charged on this hypothetical transfer is:

  • The value of the relevant property in the settlement immediately before the 10-year anniversary plus

  • The value, immediately before the time they were set up (whether or not that was within the cumulation period), of any other trusts set up by the settlor on the same day (related settlements) plus

  • The value, at the time it was put into the trust (whether or not that was within the cumulation period), of any other property in the trust which was not then, and has not at any time been, relevant property, for example, because there is an interest in possession in it.

    This means that where the only property in the trust is subject to discretionary terms and no other related settlements were made by the settlor, the assumed chargeable trans- fer will be equal to the value of the settled property immediately before the 10-year anniversary.

    This assumed transfer is deemed to have been made immediately before the 10-year anniversary by an assumed transferor who has made chargeable transfers in the seven years preceding the 10-year anniversary equal to the aggregate of:

  • The settlor’s cumulative total of chargeable transfers in the seven years before the creation of the trust plus

  • The amounts in respect of which any proportionate charges have arisen under the settlement in the 10 years before the present charge.

    Assuming there have been no payments out of the trust and no appointments of rights to capital or income from the trust in the preceding 10 years, the assumed cumulative transfers of the hypothetical transferor will be those actually made by the settlor in the seven years preceding the creation of the settlement. If the settlor has not made any transfers, the full nil-rate band will be intact.

Example

A dies in October 2005. The only non-exempt transfer made to a discretionary will trust was a collective investment worth 250,000.

A made no transfers in the seven years preceding his death.

The property remains in trust, no appointments are made and the first 10-year anniversary arises in October 2015. The trust property at that time is worth 350,000 and the nil-rate band has gone up to 300,000.

Tax is charged in October 2015 on the 350,000 relevant property then in the settlement, as shown in the table above. This charge could be seen as the tax price to pay for retaining overall discretion over who should benefit and when.

Of course, approved pension schemes are exempt from the special IHT charging regime that exists for discretionary trusts.

Even for non-pension trusts, such as the discretionary will trust or the post-death trust terms in lifetime trusts, if the value of the trust property is significantly below the nil-rate band (and there are no other additions to the chargeable amount to be taken into account, for example, transfers made in the seven years preceding the establishment of the settlement), then it may well be possible to run the discretionary trust for some time without triggering any 10-year anniversary charges.

Charge on hypothetical transfer

Value of relevant property at 10-year anniversary – 350,000

Value of property in related settlements –

Value of other property at date it entered the fund –

Hypothetical transfer – 350,000

Tax at 20 per cent on the hypothetical transfer after the nil-rate band(50,000 @ 20 per cent)10,000

Effective rate = 10,000/350,000 x 100 = 2.857 per cent

Rate of 10-year charge = 2.857 x 30 per cent = .857 per cent

Tax payable = 350,000 x .857 per cent2,999.50

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