Finance Act 2006 - changes to the inheritance tax rules affecting trusts

The changes to the Inheritance Tax (IHT) treatment of trusts announced in the Finance Act 2006 came as a great surprise to all professional advisers: there had been no prior consultation with the professions by H M Revenue & Customs (HMRC), despite the fact that HMRC had previously consulted on changes to the income tax and capital gains tax treatment of trusts.  As the Finance Bill made its way through Parliament, there were a number of modifications to the proposed changes which represent probably the biggest change to inheritance tax since its predecessor, Capital Transfer Tax, replaced Estate Duty in 1974 and 1975. Trusts have long played a part in inheritance tax planning, particularly for those whose beneficiaries are minors, and can be set up either during a person’s lifetime or under a will.

Anyone who is contemplating creating a trust, has an existing lifetime trust or has made one under a will should take professional advice on the new rules.

Prior to the changes, the inheritance tax rules distinguished between three types of trusts

1. interest in possession trusts (IIP Trusts), being trusts where income is payable as of right to one or more persons for life or a specified period of time;
2. accumulation and maintenance trusts (A & M Trusts), being trusts with some fairly tight rules set up for children or grandchildren who had to receive income by age of 25; and
3. discretionary trusts which give a complete discretion as to when and whether income or capital is paid to a beneficiary.

The IHT regime for discretionary trusts (both pre and post Finance Act 2006) provide for 10 year charge at the maximum rate of 6% and interim exit charges being a proportion of that charge.  Lifetime gifts to discretionary trusts attract a 20% IHT charge if the value of the gift exceeds the nil rate band exemption (the NRB) which is currently £312,000; if set up under a will the rate is 40% on the excess above the NRB. The changes mean that, with only a few exceptions, all trusts are now subject to the discretionary trusts regime although there are a few transitional rules applicable to existing trusts.

1.     Lifetime Trusts

(a) IIP Trusts

Trusts set up before 22^nd March 2006 are exempt from the changes unless the beneficiary changes after 6^th April 2008 then the new regime may apply. There are some exceptions for changes which occur before 6^th April 2008 and for IIP Trusts for spouses where the spouse dies after that date. 

IP Trusts set up after 22^nd March 2006 are subject to the discretionary trusts regime even if the spouse is entitled to the income.

(b) A & M Trusts

The existing A & M Trusts regime will continue to apply to pre Finance Act 2006 A & M Trusts until 6^th April 2008 at which point the property will become subject to a discretionary trust regime unless under the terms of trust, the assets go to a beneficiary absolutely at the age of 18 or, with a tax charge of 4.2%, at the age of 25.  Therefore it will be necessary to review all such trusts prior to this date.

It is no longer possible to create new A & M Trusts under the old rules: such trusts will be taxed under the discretionary trust regime and it would be better to have the greater flexibility of a full discretionary trust in the light of this change rather than the somewhat complicated old A & M Trusts rules.

(c) Discretionary Trusts

The existing discretionary trust summarised above applies to discretionary trusts whether created before or after Finance Act 2006. 

 2.      Trusts created under a will

(a)     IIP Trusts

If death occurred before 22nd March 2006 the same rules apply to both existing IIP Trusts created under a will and to lifetime IIP Trusts outlined above.

If death occurred after 22 March 2006, such trusts are now known as Immediate Post-Death Interests (IPDI Trusts), and will be taxed, following changes to the original Government proposals, as IIP Trusts under the pre-Finance Act 2006  rules. It is important to understand that such IPDI trusts can only be created under a will and it does not matter whether or not the spouse is the beneficiary. If that is the case, the spouse exemption from IHT applies.  

(b)     A & M Trusts

The regime for such trusts no longer exists post Finance Act 2006. A person wanting to make provision for a minor child under a will can either create a “bereaved minor trust” which must provide for capital to be inherited at age 18 or an “18 to 25 trust” providing for capital to be inherited at age 25 but subject to a potential additional IHT charge on inheritance of 4.2%. These rules only apply to trusts set up under wills by parents for a minor child and not by grandparents or other relatives. If the latter the full discretionary trust tax regime applies.

(c)     Discretionary Trusts

The same rules apply to such trust set up under wills both pre and post Finance Act 2006.