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Sense of proportion

What factors must be taken into account in determining the exit charge on trusts?

The exit charge, also known as the proportionate charge, has to be considered whenever property ceases to be relevant property. Broadly speaking, this is when the property ceases to be subject to the terms of the discretionary trust.

The measure of the proportionate charge is the amount by which the value of the relevant property in the trust is diminished as a result of the event giving rise to the charge (section 65(2) IHTA 1984).

If the tax payable is paid out of any relevant property remaining in the settlement, the loss will be grossed up so that the amount chargeable includes the tax.

The possible impact of the proportionate charge could be critically important in respect of life insurance policies held on trust, other than bare trusts and those falling outside the discretionary trust regime by virtue of the transitional provisions.

For example, a protection plan held on flexible/ discretionary trust may be worth very little, if anything, while the life or lives assured are alive. However, it could turn into a significant cash fund worth way over the available nil-rate band. Such is the unique nature of life insurance.

So, at first glance, it may seem that a significant exit charge could be due when a significant amount exits the trust. However, what is important to remember is that the charge on exit before the first 10-year anniversary is determined substantially on the value of the settled property when it was first settled and the rate of tax between 10-year anniversaries is determined substantially by the effective rate of tax at the last 10-year anniversary.

Special rules apply where the proportionate charge falls due before the first 10-year anniversary of a settlement set up after March 26, 1974. In this case, the rate of tax is an “appropriate fraction” of the effective rate at which tax would be charged using lifetime rates (20 per cent on amounts over the nil-rate band) on an assumed chargeable transfer equal to the aggregate of:

  • The value of all property in the settlement immediately after it commenced.
  • The value of any other property in any settlement made by the settlor on the same day (related settlements).
  • The value, immediately after it became comprised in a settlement, of any property which became comprised in the settlement after it commenced and before the exit, regardless of whether it remains comprised in the settlement.

This assumed chargeable transfer will be deemed to have been made by an assumed transferor who, in the seven years ending with the exit, had made chargeable transfers equal to the cumulative total of the settlor’s chargeable transfers in the seven years before the commencement of the settlement.

The effective rate is then found by expressing the tax chargeable as a percentage of the amount which is charged to inheritance tax. The appropriate fraction is three-tenths multiplied by so many fortieths (quarters) as have elapsed since establishment of the settlement.

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