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The transfer deadline

Richard Leeson, head of international investment at Prudential, sets out in detail the changes in tax treatment involving trust transfers for IHT planning

The new rules for inheritance tax introduced by the 2006 Finance Act have brought the tax treatment of interest in possession trusts in line with discretionary trusts.

Previously, a transfer made into a flexible trust which allowed for the beneficiaries to be changed would have been treated as a potentially exempt transfer so that no IHT was payable unless death occurred in the seven years following the transfer. But since March 21, 2006, such transfers, with a few exceptions, will be treated as chargeable lifetime transfers.

This means that they may be subject to three inheritance tax charges – an immediate charge on the transfer itself, a periodic charge every 10 years and an exit charge on money paid out by the trust.

Since the changes only affect “flexible” trusts, there is still the possibility of using absolute trusts and continuing to enjoy the potentially exempt transfer regime. This means that there is no IHT charge during lifetime regardless of the amount of the transfer and no exit or periodic charges to worry about.

Many companies have now launched both discretionary and absolute versions of their trust plans. The most common plans are loan arrangements, gift trusts and discounted gift trusts.

Loan arrangements involve setting up a trust to which a loan is then made. The loan is interest-free and repayable on death or demand and, typically, the trustees invest the loan into an insurance bond.

Repayments of the loan are usually kept within the 5 per cent withdrawal allowance to avoid immediate charges to income tax on the bond gains. Once the loan is repaid, no further monies can be paid to the creator of the trust.

This sort of arrangement “freezes” the amount lent to the trust for inheritance tax purposes since all growth on the bond belongs to the trust and is not part of the estate on death. Any amount of loan outstanding at the date of death is included in the estate.

Gift trusts are a way of effecting a transfer without allowing the beneficiary full control of the assets. The creator cannot have an interest in the trust if it is to be IHT-effective.

The discounted gift trust allows clients to retain an “income” for their lifetime and yet have the potential to avoid inheritance tax. The client invests into a plan using a trust to create two separate rights:

  • The right for the client to receive a regular payment for life, and

  • The right to the residual value on death

While the client is alive, they can enjoy the benefit of the income, although this is fixed at outset and cannot be varied.

On death, the residual value of the investment is paid to the beneficiaries. In the event that the client lives for seven years, the residual value will fall outside their estate. If death occurs within seven years of the investment, then a discount may apply which reduces the value included in the estate for inheritance tax. Any growth on the investment is outside the client’s estate and therefore avoids IHT.

It might, at first glance, be tempting from a simplicity point of view to consider the absolute versions of these trusts where they are available in order to avoid the chargeable lifetime transfer IHT charges.

However, it must be borne in mind that, under an absolute trust, the beneficiaries cannot be changed and nor can their share of the trust fund.

Furthermore, if the beneficiaries should die, their share of the trust fund is included in their estate for IHT purposes. Once the beneficiaries reach the age of 18 in England and Wales (16 in Scotland) if they are all in agreement they have the right to demand their share of the trust fund from the trustees.

Because of their inflexibility, absolute trusts may not suit clients who wish to change their beneficiaries in the future or who want to avoid IHT issues if their beneficiaries pre-decease them.

Discretionary trusts allow for changes to beneficiaries and their shares of the trust fund and because no one is absolutely entitled, the value of the fund is not included in the beneficiaries’ estate for IHT purposes. There are reporting requirements both at the outset and every 10 years thereafter.

The downside of discretionary trusts (and flexible interest in possession trusts) is the chargeable lifetime transfer regime. The lifetime rate is 20 per cent (half the death rate) on transfers over the nil-rate band (after adding to the transfer and other CLTs made in the previous seven years). If the transferor wants to pay the tax, it must be grossed up, giving an effective rate of 25 per cent.

If the creator of the trust dies within seven years, the tax is recalculated using the IHT death rate of 40 per cent and the nil-rate band at the time of death. Taper relief will apply if death occurs after year three. If, after the recalculation, there is tax due, it must be paid but if the lifetime rate was higher, there is no refund.

At the 10th anniversary of the trust (and every 10 years thereafter) a periodic charge of up to 6 per cent may be payable on the trust fund if the beneficiaries’ share (plus any relevant previous chargeable lifetime transfers) exceeds the nil-rate band at the 10th anniversary. Exit charges of up to 6 per cent may also apply on distributions from the trust in between 10-year anniversaries.

For those who are attracted to the flexibility of the discretionary trust but are put off by the lifetime rate of 20 per cent, there is the option to restrict transfers to an amount below the nil-rate band.

This is particularly easy under loan arrangements where the amount of any gift is nominal.

Under discounted gift trusts, the value of the transfer is calculated after the “discount” and therefore investments above the nil-rate band can be made without incurring an immediate charge.

Where transfers are made below the nil-rate band, care still needs to taken to explain to clients the possible periodic and exit charges that can still arise.

For loan arrangements, the value of the beneficiaries’ interest in the trust fund will be the original nominal gift and any growth on the invested loan. Since many loan trusts are set up with automatic repayments using the 5 per cent withdrawal allowance there is unlikely to be very much growth and consequently little or no periodic or exit charge.

Where gift trusts are established below the nilrate band, there will be no exit charge in the first 10 years unless the nil-rate band is reduced during that period. At 10 years, if the trust fund has grown faster than the nil-rate band, then a charge may arise.

For discounted gift trusts, the trust is valued at the 10th anniversary using the discount that would apply in year 10 if the plan were established on that date – if the client has passed their 90th birthday, then no discount would be available.

The choice of absolute versus discretionary trust will depend on a number of factors and will be different from one client to another. Care needs to be taken to weigh up the tax considerations as well as the emotive issues.

For advisers, the IHT advice market is certainly more complex than it was 18 months ago but this should offer more opportunities for acquiring and retaining high-net-worth clients and providing high-margin advice. With IHT set to continue to affect more and more people, it is an area where an investment of time and effort will reap handsome rewards.


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