When any trust is created in someone’s lifetime, the transfer of assets into the trust will constitute a chargeable transfer for IHT purposes. This means that any value in excess of the available nil rate band (£285,000 for 2006/07 and £300,000 for 2007/08) will be charged to IHT at 20%. So if an individual puts cash of £500,000 into a trust for the benefit of his children in May 2007 the IHT liability will be £40,000.
Where the assets are business assets and qualify for business property relief or agricultural property relief, that relief will reduce the IHT liability in some cases to nil.
One word of warning. If an individual creates a trust of which they are also a beneficiary, any IHT advantage will be negated by the rules on ‘gifts with reservation’ which will effectively treat the assets as remaining in the settlor’s estate.
If the assets transferred into a trust are assets within the scope of CGT, there is deemed to be a disposal of the assets by the settlor at market value. It should be possible to defer that tax charge in most cases until the assets are either sold by the trustees or transferred out to the beneficiaries.
If the trust generates income, the rules are different between discretionary and interest in possession trusts. Income of a discretionary trust is firstly taxable on the trustees at a special rate for trusts of 40% (32.5% for dividend income). If the income is paid out to beneficiaries the tax paid by the trustees will usually be offset, as the paid out income is taxed as part of the beneficiaries’ income.
Income received by an interest in possession trust will be subject to lower tax rates on the trustees. However, the income is deemed to be received at the same time by the beneficiaries and therefore there may be further tax payable by the beneficiaries if they are higher rate taxpayers.
The trustees will be liable to CGT on any assets they dispose of. They are entitled to an annual exemption which is half that available to an individual (subject to a further reduction depending on how many trusts have been established). Trustees qualify for taper relief, including business asset taper where appropriate.
An IHT charge may arise on each ten-yearly anniversary of the trust. The calculation of the charge is based on the value of the assets in the trust at the ten year anniversary. The basis of the calculation is complex but suffice it to say that currently the rate of tax payable will be 0% to 6%. Given that the assets are not chargeable on the death of a beneficiary there may be an advantage in paying these low rates every ten years.
Assets may leave a trust because the beneficiaries become absolutely entitled to the assets under the terms of the trust or because the trustees decide to advance the assets to the beneficiaries.
There are no income tax consequences when assets leave the trust other than any continuing income will be taxed directly on the beneficiary.
The trustees will be deemed to make a disposal of the assets at market value and so there may well be a CGT charge. Again it may be possible to claim a deferral of that tax liability.
When assets leave a post 22 March 2006 trust there will be an IHT exit charge. This is based on the value of the assets at that point. The precise calculation depends on whether or not exit takes place before or after the first ten year anniversary. Again the rate of charge will be 0% to 6%. Once assets are in the direct estate of the beneficiary they are potentially liable to IHT at 40%.
There are three situations in which the pre 2006 rules on interest in possession trusts continue to apply after 22 March 2006. These are:
In these three situations, there will be an IHT charge on the value of the trust assets on the death of the beneficiary.
One other type of trust which is given special treatment is known as a ‘bereaved minors trust’. This is a trust created on the death of a parent for their children with the clear requirement that the children will hold the assets absolutely when they reach the age of 18 years. These trusts will have a charge on entry but no other IHT charges. A modified and slightly less favourable regime applies where the child will take an absolute interest no later that the age of 25 years.
One important use of a discretionary trust can be in Will planning for a married couple. Transfers between spouses (or civil partners) are exempt from IHT. Although this sounds attractive in deferring tax liability until the second death, it can mean in some cases that the couple fail to use one nil rate band for IHT purposes. Using a discretionary trust written into the Will can ensure that both nil rate bands are used and can save up to £120,000 IHT at 2007/08 rates.
| Example Mr and Mrs W have a joint estate of £500,000 owned equally between them. Mr W dies and his estate passes directly to Mrs W and will be exempt from IHT. When Mrs W dies the whole estate of £600,000 is charged to tax at 40% after a nil rate band of say £300,000. This creates an IHT liability of £300,000 x 40% = £120,000. If Mr W had created a discretionary trust in his Will to take assets up to the value of the nil rate band, that would have a been a chargeable transfer for IHT but at a tax rate of 0%. Mrs W could be a discretionary beneficiary of the trust and so her position in terms of use of the assets would be protected. In this case the transfer into the trust would be £300,000. When Mrs W dies her own estate will be £300,000 and her discretionary interest in the trust in her late husband’s Will is ignored for IHT purposes. Assuming the nil rate band is still £300,000 there will be no charge on her death and overall the couple will have saved £120,000 of IHT which can effectively be enjoyed by their beneficiaries. |
The implicit assumption made so far in this factsheet is that the trusts being referred to are trusts created in and operating under UK law. Trusts do not have to be established in the UK and many jurisdictions, particularly in tax havens such as the Channel Islands, recognise the existence of trusts. Setting up trusts in such locations must involve handing over control of assets to the trustees who will, for tax reasons, need to be outside the UK. For some people this is a step too far.
Not surprisingly HMRC does not like the use of offshore trusts and over the past 15 years has introduced legislation which renders such trusts largely ineffective for individuals who are UK resident, ordinarily resident and domiciled. It is not being emotive to say that a UK domiciled individual creating an offshore trust is almost certainly inviting close HMRC scrutiny of their financial affairs.
If an individual is not domiciled in the UK there may be tax advantages across the range of taxes in using an offshore trust. The issue of domicile is too complex to go into in detail in this briefing and specific advice needs to be taken.
A non domiciled individual can shelter all their non UK assets from the scope of IHT by the use of a trust and can also gain income tax and CGT advantages by limiting the effect of the anti-avoidance legislation. Individuals who are non domiciled in the UK may become domiciled for IHT purposes after 16 years of continuous residence and should take steps to mitigate their exposure to IHT well before that stage is reached.