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Put your trusts in order

The timing of setting up trusts can now have an effect on liability to inheritance tax

Now that the Finance Act 2006 has been published and product providers are offering discounted gift schemes on both an absolute and a discretionary trust basis, if an individual is contemplating using a combination of both types of trust, the order of creation of the trusts will become important.

If they are made in the wrong order, this can affect the amount of inheritance tax that may be payable in the future.

Consider the example of David who gifts 200,000 to his son on October 10, 2006. He has not used his annual 3,000 exemptions for this or previous tax years. No IHT is payable as the gift is a potentially exempt transfer.

On November 20, 2006, David transfers 270,000 into a discretionary trust. The nil-rate band for tax year 2006/07 is 285,000, so there is no immediate IHT liability. No chargeable lifetime transfers (CLTs) have been made in the previous seven years.

David dies on June 12, 2012. He has not survived either the Pet or the CLT by seven years. The Pet becomes chargeable, and is reduced to 194,000 by the available annual exemptions for tax years 2006/07 and 2005/06.

On the assumption that the nil-rate band is 325,000 in 2012/13, 131,000 remains to set against the transfer to trust of 270,000. The excess of 139,000 is taxable at 40 per cent. As death occurred after five complete years following the transfer, 60 per cent taper relief is available, so making a tax liability of 22,240.

On the 10th anniversary of the discretionary trust, the trust fund is worth 450,000. The IHT due on the trust fund at the 10th anniversary is based on the effective rate, which is calculated as follows:

Chargeable transfers in the seven years prior to the creation of the trust (the Pet) 194,00Current value of trust 450,000644,000Less “current” nil-rate band (for 2016/17), say, 365,000279,000Tax at lifetime rate (20%)55,800Effective rate (55,800/450,000)

x 30% =3.72%

Tax due at 10th anniversary is450,000 @ 3.72% = 16,740

Now consider the position if the dates of the Pet and the CLT are switched. David’s CLT (270,000 to a discretionary trust) is made on October 10, 2006, and the Pet (200,000 to his son) is made on November 20, 2006. There is no immediate IHT liability because the CLT is within the nil-rate band, and no inheritance tax is payable on the Pet.

In this situation, the IHT on death would be exactly the same as above, 22,400.

But on the 10th anniversary of the discretionary trust, the IHT is calculated as follows:

Chargeable transfers in the seven years prior to the creation of the trust 0

Current value of trust 450,000450,000Less “current” nil-rate band (for 2016/17), say, 365,00085,000Tax at lifetime rate (20%) 17,000Effective rate (17,000/450,000) x 30% = 1.13333%

Tax due at 10th anniversary is 450,000 @ 1.13333% = 5,100

The effective tax rate has fallen from 3.72 per cent to 1.13333 per cent, making a saving of 11,640. The reason for this is that the “failed” Pet is not taken into account as it was made after the CLT, rather than before it. It should be noted that if the Pet is made first, and the settlor survives the Pet by seven years, but not the CLT, the Pet would fall out of account, thus not affecting the 10-yearly anniversary charges.

If the Pet is made first, and the settlor dies within seven years, the “failed” Pet would continue to affect the 10- yearly anniversary and exit charges as long as the discretionary trust exists.

If, instead of a Pet and a CLT, two CLTs are made within seven years of each other, the second CLT will always be affected by the first, no matter when the settlor dies. If a CLT is made first, followed within seven years by a Pet which, in turn, is followed within seven years by the death of the settlor, the CLT will affect the tax on the “failed” Pet, although the settlor survived the CLT by seven years.

It would normally be prudent to effect the discretionary trust version (giving rise to a CLT) at least one day prior to the absolute trust version (giving rise to a Pet).

Finally, if it is desired to effect a loan trust this should be set up first, as the creation of such a trust would not involve a gift and therefore not affect the tax position of either trust.

Brian Murphy is a senior financial planning manager with Axa Sun Life
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