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Serial crops

Continuing to look at how transitional serial interest relief can apply in inheritance tax planning

The best known transitional serial interest relief is that which enables a single change of beneficiary to take place under any pre-Budget 2006 trust without bringing it into the new mainstream rules for trusts, provided it is made before April 6, 2008. This general TSI is described in section 49C IHTA 1984 and was brought into play by Para 5 Part 2 Sch 20 FA 2006.

It is important to note that this relaxation can apply regardless of the nature of the asset held in trust and regardless of the occasion of charge. Its main benefit is to preserve the inheritance tax treatment of the value of the settled property in the estate for the person who has an interest in possession in it.

As well as this TSI, there is a TSI described in section 49D IHTA 1984. For the sake of completeness, it reads like this: “49D. Transitional serial interest: interest to which person becomes entitled on death of spouse or civil partner on or after April 6, 2008.”(1) Where a person (E) is beneficially entitled to an interest in possession in settled property (the successor interest), that interest is a transitional serial interest for the purpose of this Chapter if the following conditions are met.”(2) Condition 1 is that:”(a) The settlement commenced before March 22, 2006 and”(b) Immediately before March 22, 2006, the property then comprised in the settlement was property in which a person other than E was beneficially entitled to an interest in possession (the previous interest).”(3) Condition 2 is that the previous interest came to an end on or after April 6, 2008 on the death of that other person (F).”(4) Condition 3 is that, immediately before F died, F was the spouse or civil partner of E.”(5) Condition 4 is that E became beneficially entitled to the successor interest on F’s death.”(6) Condition 5 is that:”(a) Section 71A below does not apply to the property in which the successor interest subsists and”(b) The successor interest is not a disabled person’s interest.”

The upshot is that if the change of beneficiary with an interest in possession takes place after April 5, 2008 – that is, outside the general TSI provisions – then provided that under a pre-Budget trust the interest of a deceased beneficiary came to an end after April 5, 2008 by reason of death and the person inheriting was the spouse or civil partner of the deceased, the old rules applicable to interest in possession trusts would continue to apply and the charges possible under the mainstream rules for trusts – the discretionary trust regime – would not apply and the spouse exemption would apply to cover the change of interest under the trust.

In addition to this TSI provision covering deceased spouses, there are transitional provisions applying to accumulation and maintenance trusts. However, these transitional provisions are different. Unlike non-accumulation and maintenance trusts which can avail themselves of the two previously discussed TSIs, accumulation and maintenance trusts can only remain within the old rules if changes are made. There is a two-year window to do this until April 6, 2008. Basically, the trust needs to provide that beneficiaries will take an absolute vested interest no later than age 18.

The trust could defer the interest until age 25. This will not prevent the mainstream discretionary trust rules applying, they will just not commence until age 18.

The periodic charge which falls on each 10-year anniversary applies only if such an anniversary occurs after April 5, 2008. So, the first date on which the periodic charge will apply for an accumulation and maintenance trust set up on May 17, 1998, which is not covered by the reliefs above, is May 17, 2008. If the trust had been created on May 17, 1997, the first periodic charge would fall on May 17, 2017. In either case, the trust property will only have been relevant property from April 6, 2008, so the first charge will run from that date to the next 10-year anniversary.

Most pre-March 22, 2006 accumulation and maintenance trusts will not provide for assets to vest absolutely when the beneficiaries reach age 18 and many provide for an interest in possession – rather than absolute vesting – at age 25 although in many cases there may be power to appoint or accelerate capital vesting at that age.

Many trustees will now have to decide whether to incur IHT charges by adhering to the original intentions for the trust or to avoid or mitigate the IHT by altering the terms and accelerating absolute interests. In many cases, trustees may decide that the relevant property regime, with a decennial charge, is preferable to advancing assets absolutely to a young beneficiary and passing over control of substantial wealth.

Where a beneficiary is to become entitled to an interest in possession in the transitional period, any decision to advance absolute vesting should be taken before the interest vests.

There has been some understandable misunderstanding over how IHT charges can apply to age 18 to 25 trusts. The following may help to make things clearer. Although the maximum rate of tax payable is 4.2 per cent at age 25, the exit being treated as one made within the first 10 years of a discretionary trust, this rate will probably only rarely be charged. This is especially so as it is the value of the settled property immediately after it entered the settlement that will be the predominant factor in arriving at the rate of tax chargeable on the exit for most accumulation and maintenance trusts.Since Chancellor Gordon Brown’s Budget in March, one of the few financial planning tools left to inheritance tax planners, the discounted gift trust, has come into question. Despite Brown’s best efforts, is it still a useful vehicle for IHT avoidance?

These trusts have long been used as an effective way to gain an immediate reduction to inheritance tax. Using a single-premium investment bond, the discount is the result of a settlor’s retained right to the portion of the fund deemed to be needed to provide income for the remainder of their life via the 5 per cent rule. Since the retained right ceases to have value on death, there is no IHT liability. Growth is outside the estate and the remainder of the gift, until recently, was a potentially-exempt transfer since the trust used was a flexible trust.

But this was all too simple for Gordon Brown. Since the Finance Act 2006, flexible trusts have been brought into line with legislation which previously applied only to discretionary trusts. This means that the value of the gift, minus the discount, if written under a flexible trust, is now deemed to be a chargeable transfer. If the amount in question, added together with any other chargeable transfers made in the preceding seven years, is below the IHT threshold, there is no tax to pay. The sting in the tail comes if this value is over the IHT threshold, at which point there is a 20 per cent tax charge on the excess.

Added to this is the liability to a periodic charge at each 10-year anniversary. This is due where the value of the fund becomes more than the nil-rate band which prevails at that time. The discount still applies but not at its original level and will be calculated taking into account the current age and health of the settlor. The tax is equal to 30 per cent of the rate applicable to chargeable transfers – for example, 20 per cent – with a maximum rate payable of 6 per cent.

There could also be an exit charge. During the first 10 years, the calculation is more than a little complicated. It is based on the value of the funds leaving the trust and the effective rate which applied when the trust was created. This amount is then reduced to take account for the fact that a full 10-year period has not elapsed. The equation X/40 is used, 40 being the number of years over a 10-year period. Only those quarters elapsed are included in the calculation.

Exits after the first 10-year period are based on the effective rate that applied at the last periodic charge, again using the X/40 formula. Thankfully, if there was no IHT to pay at that stage, then there will not be any at exit.

This complexity has caused consideration of possible alternatives – the main one being the use of an absolute trust instead. As with all choices, there are pros and cons. The absolute trust remains part of the potentially-exempt regime and hence, on the plus side, avoids the tax regulations muddying the waters for a flexible trust.

On the minus side, flexible trusts give trustees power to change beneficiaries at any time. With an absolute trust, the beneficiaries are fixed at outset and cannot be changed at a later date. For many modern families, potential problems abound. Late additions to the family and relatives gained by default can all cause problems.

Since beneficiaries are absolutely entitled to their share of the trust fund, then it becomes part of their estate for IHT purposes, presenting another set of financial planning issues to be considered.

Another issue is that of absolute entitlement when the trust is written for the benefit of younger children. A common example would be a grandparent who effects a discounted gift scheme under an absolute trust for children under age 18. If the trust had been flexible, the trustees would have had discretion on the passing over of funds. Under an absolute basis, there is no such discretion and the worry for many will be the potential risks of passing over a large sum of money to an individual at age 18, who can then use it, or abuse it, as he or she wishes.

And so careful thought and planning is needed. Despite the offputting nature of the complicated tax rules now associated with flexible trusts, the amount of tax actually payable – if one can work out how to calculate it – is often minimal. Even if a sum is due, or is likely to become due in the future, many may see this as a small price to pay for the ability to ensure money reaches the correct hands at the appropriate time.

Julie Hedge is principal of Christie Scott’s

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