Perpetuity period and accumulation periods of spousal by-pass trusts
A spousal by-pass trust, (as it is frequently called) is a trust of lump sum pension death benefits from a registered scheme under which the deceased member’s widow/widower is a potential beneficiary.
The object of the trust is to make sure that the death benefits do not form part of the taxable estate of the member’s widow/widower yet still give them access to those funds as a beneficiary to whom the trustees can appoint benefits or lend funds.
A spousal by-pass trust will frequently be established in one of two ways. Either:
i: the member will declare a trust of death benefits under the pension plan during his lifetime and the pension scheme administrator/trustees will have to pay the death benefits to that trust we refer to this trust here as an integrated trust
ii: the pension scheme trustees/administrators will have a discretion to pay death benefits to a discretionary trust which would normally have been established with a (typically) nominal sum by the pension scheme member during his lifetime we refer to this trust as a pilot trust.
Spousal by-pass trusts can also be used to receive the proceeds of business share purchase arrangements but in this note we will focus on their use in connection with pension death benefits.
The perpetuity/ accumulation rule
Generally speaking, the perpetuity and accumulation rules exist to prevent people from tying up property in trust for unacceptable periods with a view to preventing beneficiaries from benefiting from capital and income.
The perpetuity rule of a settlement fixes its maximum lifespan. The choices as to that period will generally be 80 years or a life in being plus 21 years, with the former usually giving most flexibility. As far as accumulation of income is concerned, generally income cannot be accumulated under a trust for a period that exceeds 21 years.
As a result of the enactment of the Perpetuities and Accumulations Act, the perpetuity period is set to increase to 125 years and the restriction on accumulations is to be abolished.
The Perpetuities and Accumulations Act 2009 received Royal Assent on November 12, 2009. However, under the Commencement Order that was passed on January 5, 2010, the substantive provisions of the Act will not come into force until April 6, 2010.
The introduction of this Act will, in particular, ease the position on spousal by-pass trusts where the application of these rules currently gives rise to complications.
The current problems with by-pass trusts and pension schemes
Pension scheme trusts will, in general, be exempt from the rule on perpetuities (section 163(1) of the Pension Schemes Act 1993). However, it is generally thought that this exemption does not extend to a trust receiving death benefits because of the appointment of benefit under a pension scheme.
i: Integrated trusts
This problem does not apply in relation to integrated trusts where the death benefits (if paid) are vested in the personal trustees from the date the trust is declared. The trust will therefore adopt a perpetuity period of 80 years from outset.
ii: Pilot trusts
The position is more complex with a pilot trust.
On the basis that a pilot trust receiving the pension scheme death benefits must be given a perpetuity period (because there is no pension scheme exemption), what period should it have?
Well, one view is that it must not have a perpetuity period that could continue beyond the perpetuity period of the pension scheme had it been necessary for it to have one (that is, 80 years from the start of the pension scheme).
In other words, one would need to treat the pension scheme trust as a conventional trust and when the trustees exercise a power of appointment under that trust, make sure that any new trust stays within the original perpetuity period.
If one accepts that the pension scheme is the “head settlement” of the by-pass trust (that is, the settlement that created the main assets in the by-pass trust), this still gives rise to two issues:
a: When did the pension scheme begin? Here, at least for inheritance tax purposes, the view is often advanced that the pension scheme trust is a series of discretionary trusts in respect of each member’s benefits with each one commencing when that individual member joined the pension scheme. Whether that is the position legally is not clear
b: The 80-year period under the Perpetuities and Accumulations Act 1964 is not available where the disposition is made in exercise of a special power of appointment (the power under the pension scheme).
So where does this leave us? It means that in such cases, the safest option is to choose the life in being plus 21 years period with that “life in being” probably being the pension scheme member. This means that the pilot trust will not be capable of running for a period longer than 21 years after the member’s death which in turn means that benefits will then need to be distributed or held absolutely for a beneficiary.
It is also necessary to consider matters from an accumulation period standpoint. Here, the trust will be treated as commencing when the member joined the pension scheme with the result that it is unlikely that the trustees of the pilot trust will have much scope to accumulate income for a reasonable period of years.
This means that if the accumulation period begins when the member joins the pension scheme and death benefits are paid to the pilot trust more than 21 years after the member joined the pension scheme, there will be no scope to accumulate income in the pilot trust (and for this reason it would be better to choose an accumulation period of 21 years from the death of the member).
Perpetuities and Accumulations Act 2009
Fortunately a number of these problems will be addressed when the Perpetuities and Accumulations Act 2009 comes into force.
The rule against perpetuities will continue to apply to all trusts, except those exempted under section 2. The trusts that are exempt include “relevant pensions schemes” but not those that receive benefits by appointment from a pension scheme, that is, a pilot trust (section 2(5)).
ii: New perpetuity period general rule
The Perpetuities and Accumulations Act 2009 provides for a new perpetuity period of 125 years to replace the two current alternatives of:
i: A life or lives in being plus 21 years (at common law) or
ii: A specified number of years, not exceeding 80 years (under the 1964 Act).
This new perpetuity period will apply for trusts commencing after the Act becomes effective (section 5). The period will start from the date when the trust creating the interest in question takes effect.
iii: Exception to the general rule
However, in a case where a trust is made by virtue of the exercise of a special power of appointment created under a trust that was in existence before the Act came into force, the perpetuity period will be that stated in the original trust and treated as starting when the original trust started.
A non-pension trust created on July 1, 1980 with an 80-year perpetuity period from that date includes a special power of appointment which is exercised after the Act comes into force. The perpetuity period of any trust created by the power will be 80 years starting on July 1, 1980.
iv: Exception to the special power rule
The period applicable to the special powers of appointment in (ii) above is, however, subject to an exception where benefits are nominated or a power of advancement is exercised under a relevant pension scheme.
The exception is necessary because in cases where the power is created by the pension scheme, it would not make sense to provide that the period that applies is the period applicable to the pension scheme, because in most cases the pension scheme will not be subject to the rule against perpetuities and so will not have a perpetuity period.
Also, it may have been created long before the member concerned joined the pension scheme.
So in such cases, the Act provides, in section 6(3), that the perpetuity period is 125 years starting when the member concerned joined the scheme.
Bob joined his pension scheme in 1983. He died in 2011 and the scheme administrator paid death benefits into a pilot by-pass trust. The perpetuity period of the by-pass trust will be 97 years basically the unexpired period of 125 years since Bob joined the pension scheme.
The statutory rule against excessive accumulations will be abolished so that under new trusts it will be possible to accumulate throughout the duration of a settlement, that is, 125 years.
However, this will be subject to any express provisions in the trust deed and so care needs to be exercised here.
At present, trust deeds are normally drafted to give trustees particular powers to deal with income limited to “the accumulation period” which is typically 21 years from the date the trust takes effect.
In the future, trustees should either be given power to accumulate “for the trust period” or the accumulation period should be defined as “the trust period”.
The rule on accumulations will be retained for charities where two accumulation periods are available either 21 years or the life of the settlor.
vi: Date of effect
The Act will apply to trusts taking effect and wills executed after the Act comes into force on April 6, 2010.
Trusts already in existence are, therefore, not affected. However, where, under a trust created before the provisions come into force, there is a “lives in being” perpetuity period, it can be difficult to determine when the perpetuity period ends.
The new Act provides that, in such cases, trustees can execute a deed providing that the perpetuity period will become a fixed 100 years.
Impact on spousal by-pass trusts
i: Integrated trusts
Under an integrated scheme, there is no appointment by the pension scheme trustees they must pay benefits to the trustees of the integrated trust. Therefore section 6(3) does not apply.
Once the Act comes into force, new integrated spousal by-pass trusts should be established with a trust period (perpetuity period) of 125 years from the date the trust is declared. The accumulation period would normally be expressed to be the trust period.
Existing integrated spousal by-pass trusts will continue with the perpetuity period that was expressed in the trust at outset presumably 80 years.
ii: Pilot trusts
New discretionary pilot trusts will use a perpetuity period of 125 years. The accumulation period could be the same.
If death benefits are paid to the trust from a pension scheme, the perpetuity period for that part of the trust fund will be 125 years from the date the pension scheme member joined the pension scheme.
In many cases, the pension scheme member will still be alive and a pilot trust will already have been established for a nominal amount with the scheme administrator/ pension scheme trustees having been given an expression of wishes to make a payment to this trust. Such trusts will frequently have a perpetuity period of a life in being plus 21 years.
If a death benefit is paid to such a trust after the Act has become effective, it could be argued that the perpetuity period for the part of the trust fund representing the death benefits is 125 years from the date the member joined the pension scheme.
Generally speaking, the perpetuity and accumulation rules exist to prevent people from tying up property in trust for unacceptable periods with a view to preventing beneficiaries from benefiting from capital and income
In order to avoid complications in such cases, once the Act is effective (and assuming the member is still alive) it may be appropriate to establish another trust for a nominal amount with a longer appointment period and for the member to sign an expression of wishes in favour of that new trust. The establishment of the new trust would give rise to future inheritance tax planning opportunities because, under current IHT rules, the two trusts would not be related and so would each qualify for a nil-rate band.
The possible downside of having two trusts is that the first trust declared will dilute the capital gains tax annual exemption available to the second trust in the event that death benefits are paid to this trust and investments made.
This problem could be avoided by the trustees making an absolute appointment of benefits (that is, the nominal amount) under the first trust while the member is alive. This will effectively wind up the first trust and mean the second trust will be entitled to a full trustee CGT exemption.
For persons considering establishing a pilot trust now unless they are in serious ill health, it would probably be best to wait until the Act has come into force and then declare the trust.