Can trusts be trusted following the Finance Act? – Standard Life Savings & Investment Ezine

Standard Life's Savings & Investment newsletter for advisers

Issue 2: Dec 2006

Schedule 20 of the Finance Act 2006 (FA 2006) has forced advisers to re-think the way they go about trust based lump sum Inheritance Tax (IHT) planning.

Prior to the FA 2006, many trust based schemes took advantage of interest in possession trusts (commonly referred to as flexible trusts) in combination with single premium life assurance bonds. The advantage was that the gift into this type of trust was a potentially exempt transfer (PET) and so would not result in an immediate IHT charge, regardless of the size of the gift.

Post FA 2006, the landscape has changed. Flexible trusts no longer enjoy this privileged treatment, and gifts into such trusts on or after 22 March 2006 are now treated in the same way as gifts into discretionary trusts; that is they are treated as chargeable transfers (CTs). This means that if the gift, when added to any other CTs made in the seven years prior to the gift, exceeds the IHT nil rate band (currently £285,000), there will be an immediate IHT charge on the excess at the lifetime rate of 20%.

Can this immediate charge be avoided? The answer is yes. By splitting the investment into two trusts, one absolute (or ‘bare’) trust and one flexible trust, the CT can be kept below the available nil rate band and an immediate charge avoided. We can see how this might work in an example;-

Let us suppose that George wishes to invest £500,000 in an IHT efficient way. He has not previously made any gifts, other than to use up his annual IHT gift exemption of £3,000 every year. If he gifts the whole £500,000 into one flexible trust, this will be a CT of £500,000.

There will be an immediate tax charge calculated as follows:

If, instead, George makes a gift of £215,000 into an absolute trust, and £285,000 into a flexible trust, there will be no immediate IHT charge. The gift into the absolute trust will be a PET, which will only become chargeable if George were to die in the next seven years. The gift into the flexible trust will be a CT of £285,000, but as this is matched by the current IHT nil rate band, there will be nothing to pay immediately on this transfer either.

So by dividing the gift in this way, George would avoid an immediate tax charge of £43,000.

If George survives these gifts by seven years, there would be no further tax at all on the gifts themselves. However, the flexible trust, being a ‘settlement’ for IHT purposes, would be subject to the 10 yearly periodic charge. There would not be a periodic charge on the absolute trust as this is not regarded as a settlement for IHT purposes.

To analyse the impact of the periodic charge on George’s flexible trusts, let us assume that the nil rate band has increased to £400,000 in 10 years time, and that over the same period, the investment has doubled. Also, no capital is distributed to any beneficiaries in the first 10 years.

Had George just made the one gift of £500,000, the periodic charge would be calculated as follows:

Compare this to the situation had George split the gift between a flexible trust and an absolute trust. As we have already said, there will be no periodic charge on the absolute trust. We only need to consider the gift into the flexible trust of £285,000. Provided George survives the original gifts by seven years, the periodic charge would be as follows:

Clearly, the periodic charge will be less where the original gift is divided into two trusts. There is, however, a price to pay for this tax benefit. The trustees will have no discretion over who can benefit from the absolute trust. That is to say the beneficiaries chosen by the settlor at outset can never be changed.

Provided that the loss of flexibility is not an issue for George, he will reduce the total IHT liability if he chooses to make two gifts.

Is there anything else George needs to consider when setting-up the plans? Well, so far we have assumed that he survives the date of making the gifts by seven years. If this is the case, it would not really matter in which order the trusts were created. However, we also need to consider the scenario should George die within seven years. This time, in respect of the periodic charge on the flexible trust, the order does actually matter.

This is because the gift into the absolute trust is initially a PET, but the death of George within seven years will make it a CT. When the periodic charge is being assessed on the flexible trust, any CT made in the seven years before its creation will affect the calculation of the periodic charge.

Assume George sets-up the absolute trust first, followed by the flexible trust the following week. If George dies within seven years of creating the absolute trust, the £215,000 PET becomes a CT. As it is a CT in the seven year period before the gift into the flexible trust, the periodic charge on the flexible trust will be:

This is still an improvement over the position of a £36,000 periodic charge for the one gift scenario in Example 2. But we can do even better!

What if the trusts were created in the reverse order, with the flexible trust first?

Whilst George’s death within seven years will still make the transfer into the absolute trust a CT, it now occurs after the flexible trust, and so will not affect the periodic charge calculation. The calculation of the tax at the periodic charge date would be the same as in Example 3 above. The periodic charge has reduced from £23,100, to £10,200.

To summarise, by dividing the gift into an absolute trust and a flexible trust as described above, George can avoid any immediate IHT charge. He will also be able to minimise the periodic charge after 10 years by ensuring that the flexible trust is created before the absolute trust, whether or not he dies within seven years of starting the plans.

If he did die within seven years, as the PET becomes chargeable, there will be some tax to pay on the original gifts, but this will never be more than the total amount paid if only one gift of £500,000 had been made. If death occurred after five years, the amount paid on the two gifts would actually be less.

Standard Life has absolute and flexible trust versions of its Gift Plan, and a flexible version of its Discounted Gift Plan, which could be used in conjunction with the above planning ideas.

Tax and legislation are liable to change. The information given here is based on Standard Life's understanding of law and HM Revenue & Customs practice at the date of publication. Tax reliefs may be altered and their value to the investor depends on their financial circumstances. No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of this content.