This article looks at the tax consequences of making an appointment, or changing an individual’s interest or entitlement, under a pre-22 March 2006 trust.
Background
Before 22 March 2006, any lifetime transfers into Interest in Possession (IIP) and Accumulation & Maintenance (A&M) trusts were exempt from inheritance tax (IHT), as long as the Settlor survived seven years. This was because the transfers were treated as potentially exempt transfers (PET). These trusts were also exempt from the 10-yearly periodic charge and the exit charge that are generally associated with discretionary trusts.
However, transfers into most new trusts created on or after 22 March 2006 are no longer treated as PETs, unless the trust is a bare or absolute trust. From this date, gifts into such trusts are immediately chargeable to IHT. However, there is no immediate charge if the value of the transfer (including transfers in the previous seven years) is within the available nil-rate band (£325,000 for 2013/14). These trusts will also potentially be subject to the 10-yearly periodic charge, the exit charge and the additional charge on death of the Settlor within seven years.
The impact of IHT on IIP trusts
Before 22 March 2006, flexible trusts were a popular structure. A major benefit was that the beneficiary(ies) who had an interest in possession (IIP – the right to any income) could be changed. This only had a potential IHT impact if the IIP beneficiary was to die within seven years of the interest being removed.
Post-22 March 2006, changing the IIP beneficiary’s interest will potentially move the trust fund, or part of it, into the new relevant property regime. This could mean that tax has to be paid either immediately or in future years (or both).
Death of the IIP beneficiary
Where an IIP trust ends because an existing IIP beneficiary dies, the value of the IIP will be treated as an asset of the beneficiary’s estate for IHT purposes. Therefore the policy will not be caught by the new regime.
If an IIP created before 22 March 2006 ended before 5 October 2008 – whether on death or otherwise – the new IIP that arises will continue to be treated as a pre-22 March 2006 for each relevant share of the trust fund.
Therefore, the relevant property regime will not apply to this share of the trust, unless the later IIP ends during the lifetime of the beneficiary and after 5 October 2008.
HMRC has confirmed that where a beneficiary is changed after 5 October 2008 for any reason other than death, the transfer of value will be based on the ‘loss to the estate’ principle, and it’s that proportion which is treated as relevant property. For example, if there is one beneficiary and a second is added, the transfer of value would be half that which the existing beneficiary had given up.
Gift with Reservation (GWR)
The IHT GWR rules have been extended to include termination of an IIP on or after 22 March 2006. The rules apply to beneficiaries who have had their beneficial interest removed, but they still remain a potential beneficiary. This will be treated as a disposal of the property in which the interest was a gift, and therefore the GWR rules will apply.
For example, if the trustees terminate a beneficiary’s pre-22 March 2006 IIP in a house but the beneficiary continues to live in it, the house will be property that’s subject to a reservation in the beneficiary’s estate. Therefore it will be liable to IHT.
The gift with reservation of benefit provisions described above will also apply to life assurance policies. The reservation of benefit is limited to the share of the trust fund being transferred away from the pre-22 March 2006 IIP beneficiary. To avoid any GWR, the beneficiary would need to be excluded from any future benefit.
Trustees should consider whether excluding the beneficiary from the trust fund is prudent for that beneficiary (this will create a PET), or whether it would be better for all beneficiaries if the reservation was maintained but the share of the trust fund was appointed to the new beneficiary absolutely.
When looking at pre-22 March 2006 trust arrangements, financial advisers should consider the tax consequences of any change and the overall objective of the trust. Meeting the needs of the beneficiaries may mean some tax has to be paid which originally would not have been expected. However, the tax payable may not be as onerous as expected, and ultimately this should not be the sole driver of investment or trust management decisions.