Private Client UPDATE

Issue No.4 December 2006

TRUSTS – SWEEPING NEW TAX RULES

Are you the settlor or a trustee of a lifetime trust? Does your Will include the creation of trusts e.g. for your spouse, children or grandchildren? If so, you should be aware of sweeping new tax changes introduced by the Finance Act 2006. The new tax rules for trusts are complex and the treatment of trusts created by will and those created during the Settlor’s lifetime is different. We highlight a few of the changes below.

What are the new rules concerning lifetime trusts made after 22 March 2006?

Very broadly it will not now be possible to create new accumulation and maintenance trusts (A&M) i.e. particular trusts benefiting mainly those under 25 which had enjoyed especially lenient capital tax treatment. The tax treatment of new life interest trusts (or interest in possession “IIP” trusts) will also change. With very limited exceptions the life tenant (or person entitled to the income of the trust during his or her life) will no longer be treated for inheritance tax (IHT) purposes as if they owned the underlying capital.

Can trusts created during my lifetime still be treated as Potentially Exempt Transfers?

No. Under the old regime, transfers into A&M and IIP trusts were Potentially Exempt Transfers, meaning that if the Settlor (S) survived the transfer by 7 years, the value of the transfer would not be aggregated with the value of S’s estate on death. Now, new lifetime trusts (other than certain trusts for the disabled) will be taxed in the same way as discretionary trusts. This will mean that from 22 March 2006, subject to certain transitional provisions, all new A&M or IIP trusts where the value is over the nil rate band (currently £285,000) will be subject to a 20% IHT charge on creation (rising to 40% if S dies within seven years), the trust fund will be subject to ten year periodic charges of up to 6% and an exit charge when property leaves the trust of up to 20%. This is called the “relevant property regime” and is a much more draconian tax treatment than was previously enjoyed by A&M and IIP trusts.

There are certain exceptions to the new tax regime but the Government is clearly now viewing trusts as a tax raising vehicle rather than appreciating their benefit as asset protection vehicles for younger generations.

Will all trusts created by will or on intestacy also be subject to this same tax treatment?

No. There are certain, limited exceptions. Some of the most important exceptions are:

Bereaved Minors Trusts

Such trusts must be for the child of the deceased. The child beneficiary must take the capital by the time s/he becomes 18. Such trusts will be outside the new above-mentioned taxing regime but any tax benefit should be weighed against the disadvantage of the child being required to take the capital at such an early age. Note also that grandparents cannot create these trusts for grandchildren.

18 – 25 Trusts

Another exception is trusts for 18-25 year olds. Again the beneficiary must be a child (not e.g. a grandchild) of the deceased. The trust will be exempt for IHT purposes whilst the child is under 18. Thereafter, if the child receives the trust assets (or dies) between 18-25 an exit charge will be made on the value leaving the trust. The rate of this tax increases the longer the assets are left in trust to a maximum of 4.2% at 25. No periodic charges will be made if the capital vests between 18-25. However, if the assets remain in the trust beyond when the child is 25 the above mentioned “relevant property regime” (equivalent to the old IHT charging structure for discretionary trusts) will begin. These trusts do not escape the new trust regime entirely, but you may well consider the relatively low tax charge worthwhile in order to keep capital outside the hands of a young person until they reach 25 or an age between 18-25.

There are other very limited exceptions which we would be pleased to advise on if you contact us.

Are existing A&M trusts affected?

Yes. There are various complex transitional arrangements that apply to existing A&M trusts. Any transitional arrangements must be put into effect before 6 April 2008. The most important point to appreciate is that to achieve the most favourable tax regime, the children must be entitled to receive the assets no later than 18. Many will consider this too young, but unless this change is effected, after 6 April 2008 the favourable tax treatment for existing A&M trusts will be removed. They will instead become subject to the above mentioned “relevant property regime”. Therefore, if you are the settlor or a trustee of an existing A&M trust, do contact us now to consider whether you should take action which could reduce adverse tax consequences.

Will the nil rate band still apply?

Happily, yes. Gifts of property by will or during your lifetime, which, when aggregated with the value of other gifts made in the preceding seven years are less than the nil rate band (currently £285,000) will escape the new tax charges. For married couples we therefore continue to champion (depending on your circumstances) the inclusion of gifts of up to the nil rate band limit or the inclusion of nil rate band trusts into Wills. For lifetime tax planning, in addition to the usual modest actions that can be taken to reduce the incidence of IHT by small amounts (we will be pleased to advise on these) you could also consider making either outright gifts or gifts into discretionary trusts of an amount up to the current nil rate band. For long term tax planners once seven years have elapsed, under current rules, a fresh gift of up to the then current nil rate band can again be made.

As we mentioned at the outset, the new rules have made trust regimes very complex. We will be pleased to help guide you through the new rules and to suggest ways to reduce the incidence of inheritance tax on your estate or on any lifetime gifts into trust that you may be planning. Do contact us for such advice. If you already have a lifetime trust it would be helpful if you could let us have a copy of that for further discussion.

Note:

Please note that this newsletter is not intended to be a comprehensive statement of the law and should be used for guidance purposes only. If you require specific legal advice please contact Nick van der Borgh or Sharon Rutter or by telephone 020 7493 2903.