CHANGING THE IMPLICATIONS OF THE MELVILLE CASE
In the Summer of 2001, the Court of Appeal held that the terms “property”, “interest” and “right” included a general power of appointment for inheritance tax (IHT) purposes. This meant that the use of a discretionary settlement reserving valuable rights for the settlor was confirmed as an effective mechanism for holding over gains on non-business assets which have a market value way in excess of the settlor's nil-rate band, without an immediate IHT liability arising. However, the decision also created unexpected liabilities with regard to trusts under which powers were created by people believing them to have no value for IHT purposes.
The Chancellor has proposed that, in future, such powers will be disregarded for IHT purposes. Therefore, as well as blocking the “valuable” discretionary trust IHT tax avoidance opportunity, this change will restore the law to the position most people thought existed.
Over recent years some taxpayers have been using a special type of discretionary trust arrangement to enable them to elect for hold-over relief for capital gains tax (CGT) purposes under s260 TCGA 1992 when placing investment (ie. non-business) assets that are substantially in excess of the nil-rate band, into a discretionary trust but without incurring the usual 20% lifetime charge to IHT. This is achieved by the settlor retaining a valuable right under the trust to require the trustees after 90 days to appoint the trust fund to anyone, including himself. Because IHT is calculated on a “loss to the estate” principle and the settlor retains a very valuable right, the transfer of value is minimised. This scheme was challenged by the Inland Revenue in the High Court on 20 June 2000 in the case of Melville & Others -v- IRC.
The case focused not so much on the CGT advantages but on the technical issue of whether the right of the settlor was “property” within the meaning of s272 IHTA 1984 which, as retained by the settlor, reduced the transfer of value made by him under s3(1) IHTA 1984. The Court held the settlor's right was property and accordingly found in favour of the taxpayer.
The Inland Revenue appealed. Subsequently, the Court of Appeal delivered their decision in favour of the taxpayer on 31 July 2001, dismissing the Revenue's appeal against the High Court decision. Accordingly, the use of a discretionary settlement reserving valuable rights for the settlor (which were subsequently released) was confirmed as an effective mechanism for holding over gains on non-business assets which have a market value way in excess of the settlor's nil-rate band, without an immediate IHT liability.
At the time, it was noted that this decision could present some unfortunate side effects to other taxpayers. For example, the right to revoke a settlement (not uncommon with non-UK settlements) would now be considered as “property” for IHT purposes. Consider an excluded property settlement made by a non-UK domiciliary who subsequently dies while deemed UK domiciled. Although, if situated outside the UK, the trust fund will be excluded property so far as the settlor's estate is concerned, IHT will be charged on his world-wide estate which would include the right to revoke (even if as a matter of general law it is situated outside the UK).
There could be a further problem for certain trusts with a life tenant settlor with the right to revoke a settlement. The settlor will be regarded as owing the trust property for IHT purposes. However, under Melville, the right to revoke seems to be a free-standing right with a value equal to that of the property in the trust fund. There could therefore be double taxation.
The problem stems from the use of discretionary trusts to hold-over capital gains and in this respect the Inland Revenue had previously hinted in their 1991 consultative document on the income tax and CGT treatment of UK resident trusts that these rules should be changed. In this document, they remarked that it would not be difficult for the Government to introduce legislation which limited the hold-over facility to the extent that lifetime IHT was actually paid. However, no change was ever made so that provided the transfer of value to a discretionary trust did not cause the settlor to exceed his nil-rate band, full CGT hold-over relief could be obtained with no immediate payment of IHT.
Following the Melville decision, the continuing future ability to hold over non-business gains under s260 TCGA 1992 within the nil-rate band was thought to be susceptible to a change in legislation.
Fortunately, the Government have only deemed it necessary to take action to prevent Melville planning and clarify the position on the valuation of trust powers. This is very good news as nil-rate band discretionary trusts are still alive and kicking as attractive planning tools. Where a CGT liability will arise on assets an individual wishes to gift – perhaps because they are part of an investment share portfolio – then the possibility of a gift to a discretionary trust could be considered as this will allow the investor to claim CGT hold-over relief. This will defer the capital gains tax on the asset until the trustees later dispose of the investments.
Whilst this is therefore a valuable planning tool for somebody who wants to make lifetime gifts, there are drawbacks to consider because:-
- clearly as the investor had disposed of the asset, it no longer belongs to him so there will be no CGT uplift in the value of the asset on the investor's death. Instead the gain has been passed on to the trustees. For this reason, this planning may not be appropriate for the elderly investor who really needs to live for 7 years to achieve IHT benefits
- when calculating the held-over gain, taper relief cannot be taken into account
- on a subsequent disposal by the trustees, taper relief runs from the date of acquisition by the trustees (assuming a further hold-over claim is not then made)
- if the value of the gift causes the investor to exceed his IHT nil-rate band (£250,000) immediate lifetime IHT will be paid at 20% on the excess.
It is this latter drawback that the Melville trust sought to overcome. In other words, it enabled a person who had assets with a value well above their nil-rate band to make a gift, avoid CGT by claiming hold-over relief and to also avoid the need to pay immediate IHT. In effect the transfer of value for IHT was measured by reference to the loss to the investor's estate and because the power of revocation/appointment is a very valuable right, frequently the loss to the estate can be restricted to a figure that falls well within the investor's nil-rate band.
Typically, at a later date the investor would have directed that the benefits of the trust will be held on interest in possession trusts for the benefit of the family and so at that time he makes a PET of his valuable right but with no further disposal for CGT purposes by the trustees. Any discretionary trust exit charge will be minimal because the change occurs soon after the settlement began. Consequently, the end result is that the settlor has, in the main, made a PET of the investments but with a full CGT hold-over relief claim.
This type of planning will no longer work but the genuine nil-rate band discretionary trust lives on.
As discussed earlier, the decision in Melville may also have caused some adverse inheritance tax implications for excluded property trusts in cases where the settlor is non-UK domiciled when he established the trust but subsequently attains UK domicile status and the settlor has a power of revocation under the trust. Fortunately the proposed changes will now avoid such problems.