Neil Jones is Technical Support Manager with Canada Life’s ican Technical Services Team.
Canada Life offers a range of wealth management solutions, including retirement income planning, estate planning and investment solutions from a choice of jurisdictions, including the UK, Isle of Man and Republic of Ireland.
A trust can offer significant advantages when an individual is looking at how to reduce the potential inheritance tax (IHT) that could be payable on their death and over the last ten years many have used a discretionary trust as a suitable solution. It allows people to remove money from their estate and gives the trustees discretion as to who benefits, when they benefit and by how much.
However, IHT is not only payable when someone dies, but can also fall due when money is settled into trust, on every tenth anniversary and when any money is distributed to beneficiaries. Even if no tax charges apply, the trustees may have a responsibility to report details of the trust to HMRC. So let us look at how these changes came about and when these tax charges can apply.
As we are looking at lifetime gifting the new resident nil rate band does not apply as this is only available on death.
Relevant property regime
In the 2006 Budget, then Chancellor Gordon Brown changed the IHT treatment of trusts so that most trusts effected on or after this date fall under the relevant property regime. Any non-exempt transfers into relevant property trusts are treated as a chargeable lifetime transfer.
Prior to these changes, advisers and clients had widely used flexible trusts and the gift into the trust was treated as a potentially exempt transfer. As the new rules meant that flexible trusts and discretionary trusts both fell under the relevant property regime, the use of discretionary trusts became more popular as they offer greater flexibility.
There are other trusts that can fall under the relevant property regime, but for this article we will consider discretionary trusts.
As money settled into a relevant property trust is a chargeable lifetime transfer, where the total chargeable lifetime transfers made in a rolling seven year period exceed the IHT nil rate band (NRB), currently £325,000, an entry IHT charge applies. This amounts to 20% of the excess over the available NRB and falls on the trustees to pay from the trust property. For this reason many settlors will try and avoid exceeding the available NRB and keep gifts into such trusts within this limit and use the exemptions available.
Looking at an example:
- Eric settles £125,000 into a discretionary gift trust in April 2014.
- He considers settling a further £325,000 into a new discretionary gift trust in June 2016, being his NRB.
- Besides using his exemptions he has not made any other gifts.
- The total chargeable lifetime transfers in the seven year period will total £450,000 and exceeds the NRB of £325,000. The excess amount of £125,000 would be subject to a 20% tax charge, leaving the trustees with a tax bill of £25,000.
- Eric restricts the settlement to the second trust to £200,000 and therefore avoids an IHT entry charge as the total amount settled does not exceed the available NRB.
Ten-yearly IHT charges
On each 10-year anniversary of the start date of the trust the trustees have a responsibility to calculate if a charge applies and whether the trust needs to be reported to HMRC. This charge is also known as a periodic charge.
First, the trustees will need to establish the available NRB. The amount available to them will be the NRB at the tenth anniversary less any chargeable lifetime transfers made by the settlor in the seven years prior to this trust being created. From this you can see that the trustees will need to be aware of previous transfers made by the settlor and that these gifts can have an impact for the lifetime of the trust.
In Eric’s example:
- The NRB has remained at its current level of £325,000.
- As Eric made a chargeable lifetime transfer of £125,000 in the seven years prior to the settlement of trust two, the available NRB for this trust is reduced from £325,000 to £200,000.
The trustees then need to take the value of the trust on the tenth anniversary plus any distributions from the trust to the beneficiaries in the previous ten years. If this total exceeds the available NRB then a periodic charge is due. This is calculated as 30% of the lifetime rate of IHT. As lifetime IHT is 20% then the periodic charge is 20% x 30% = 6%.
Again, taking Eric’s second trust:
- Its value has grown from £200,000 to £300,000 over 10 years.
- There were no distributions to the beneficiaries.
- The excess over the available NRB is £100,000.
- This results in a ten yearly IHT charge of £100,000 x 6% = £6,000.
- The trustees will need to report this and pay the amount due within six months of the tenth anniversary.
Calculating the value of a trust is relatively straightforward for normal gift trusts, however it is a little more complicated for gift and loan trusts and discounted gift trusts.
- Under a gift and loan or loan trust, any outstanding loan due back to the settlor needs to be deducted from the value of the trust. The trustees have an outstanding liability that needs to be taken into account when calculating the net value of the trust.
- For a discounted gift trust, if the settlor is still alive then the trustees have an obligation to provide the regular payments to them and the actuarial value of this commitment should be deducted from the value of the trust property. At outset this is represented by the discount and will be based on the settlor’s life expectancy and the level of payments they have chosen to receive.
HMRC have confirmed that there is no need to medically underwrite the settlor again. The settlor has aged ten years so to calculate the discount on the tenth anniversary it is acceptable to add 10 years to the age or rated age that was used at the previous tenth anniversary, or at outset if it looking at the first tenth anniversary.
The value of this recalculated discount can be deducted from the value of the trust and if the settlor has died then there is no commitment for the trustees to provide any payments and therefore no discount applies. The full value of the trust is then used in this calculation.
When looking at distributions that need to be factored into the periodic charge calculation, these are distributions to beneficiaries.
If the trust allows reversions back to the settlor and these are correctly carved-out in the trust at outset, they will not be treated as distributions, for example discounted gift trusts and flexible reversionary trust. Neither will any loan repayments made to a settlor under a gift and loan trust.
Whether a 10-yearly anniversary IHT charge is payable or not the reporting requirements apply where the value of the trust is over 80% of the available nil rate band (currently, £260,000). The trustees may therefore have an obligation to report the trust to HMRC even though no tax charge arises.
Distributing money to beneficiaries – IHT exit charges
An IHT exit charge could apply depending on when the distributions are made and whether an entry charge applied at outset, if the distribution is in the first 10 years, or a periodic charge has applied at the previous tenth anniversary if the distribution is made after this. Where a periodic charge is due the effective rate of tax of the trust needs to be established and a pro-rata tax charge is applied. First let us look at the effective rate of tax applying to the trust.
- Distributions in the first 10 years.
These are subject to an exit charge if there was an entry charge but if there was no entry charge then there are no exit charges for the first 10 years.
If tax was due at outset then despite 20% tax being paid on the excess over the available NRB, the effective rate of tax for the exit charge is based on a hypothetical calculation using the rate that would apply for periodic charges.
- If Eric had settled £325,000 into the second trust, his total chargeable lifetime transfers would have exceeded the NRB by £125,000.
- The trustees would have paid an entry charge of £125,000 x 20% = £25,000.
- The hypothetical rate as a periodic charge would be £25,000 x 30% = £7,500.
- The effective rate of tax payable as a percentage of the value is £7,500 / £325,000 = 0.0231%
- Distributions after the first 10 years
These are subject to an exit charge if there was a periodic charge at the previous tenth anniversary. If there was no periodic charge on the previous tenth anniversary then no exit charges will apply.
- Eric only settled £200,000 into the second trust and this has grown to £300,000.
- The trustees paid a periodic charge of £6,000.
- The effective rate of tax payable as a percentage of the value is £6,000 / £300,000 = 0.020%
Once you have the effective rate of tax applying to the trust, this tax rate is then applied to the amount of the capital distribution and this is based on the number of complete calendar quarters since the previous ten-year anniversary, or since outset if within the first 10 years.
Taking Eric’s second trust again:
- The trustees paid the £6,000 10-yearly IHT charge as detailed in example above in June 2026.
- In June 2028 the trustees then distributed £20,000 to the beneficiaries; two years into the next 10-year period.
- As the distribution is made eight quarters into the next ten year period, the exit IHT charge is reduced by 8/40.
- The exit IHT charge is therefore £20,000 x 0.020% x 8/40 = £80.
The possibility of IHT charges on trusts is not unlikely and adviser firms will come across these more now that we have seen ten years pass since the changes made in 2006. Many advisers have helped clients with estate planning, but the trustees of these arrangements will need help and guidance to understand their reporting obligations, how to calculate if any tax is due and how much this tax is.