The case of Rysaffe Trustee Co (CI) Ltd v Inland Revenue Commissioners (2003), where a series of trusts were created on consecutive days, is often referred to within discretionary trust planning.
The principle is that by establishing a series of smaller trusts, the impact of the 10-yearly periodic charge and exit charges can be reduced by establishing a nil-rate band for each trust.
Under the statutory definition of “related settlements” contained in section 62 Inheritance Tax Act 1984, related settlements are treated as a single settlement and so would not each have a separate NRB.
For two or more trusts to be related settlements, the settlor must be the same in each case and the trusts must have commenced on the same day. Conversely, trusts created on different days cannot therefore fall within this definition. Putting this principle into practice, creating a series of trusts rather than a single trust could reduce the amount of inheritance tax due.
Consider, for example, a client who wants to place a £300,000 investment into a discretionary trust. Assuming the amount is made as a one-off payment and the full NRB is available (and other exemptions have been used elsewhere), the tax liability at entry would be calculated as 20 per cent (half the death IHT rate) of the £15,000 over the NRB, equating to £3,000.
Alternatively, three trusts of £100,000 could be created on separate days. The entry charge would still be £3,000. For the first trust, there are no previous CLTs and the fund of £100,000 is less than the NRB so there is no tax due. For the second trust, there is one previous CLT of £100,000 (from the first trust) which needs to be taken into account but the total of £200,000 is still less than the NRB so there is no tax due. However, for the third trust, both previous CLTs are taken into account, bringing the total of £300,000 over the NRB. The tax due is 20 per cent of the £15,000 that is over the £285,000 limit, again equating to £3,000.
Although the entry charge is the same whether one or three trusts is created, the same does not hold true for the exit and 10-yearly periodic charges.
Suppose the trust grows to £600,000 by 2016 and the NRB rises to £400,000 (approximately 3 per cent a year growth over what has already been announced) and there have been no other previous CLTs or exit charges. If a single trust had been created, the 10-year periodic charge would be calculated as follows (see table below):
Therefore the 10-year periodic charge is equal to the current value of the trust fund (£600,000) x 2 per cent, which is £12,000.
Thus £12,000 is due at the 10th anniversary and there will be tax on any later distributions of capital in the following 10 years.
In comparison, suppose instead three trusts of £200,000 each were created on separate days. For the first trust, there are no previous CLTs in the seven years before its creation and no distributions that give rise to an exit charge. The current value is £200,000, which is less than the nil rate band of £400,000, so the 10-year periodic charge is £0.
For the second trust, the previous CLT of £100,000 from trust one needs to be taken into account, bringing the total up to £300,000, but this is still less than the NRB. Again, there are no distributions that give rise to an exit charge so the 10-year periodic charge is £0.
For the third trust, both previous CLTs of £100,000 each are taken into account. Added to the current trust fund value of £200,000, the total is £400,000. This is equal to the NRB so once again there is no 10-year periodic charge to pay.
Thus a series of trusts has been created where the 10-yearly periodic charges are zero and any later exits in the following 10 years will also be taxed at this rate.
Colin Jelley is head of tax and financial planning at Skandia