The changes announced in this year’s Budget to the Inheritance Tax (IHT) treatment of trusts have now been finalised in the Finance Act 2006 after undergoing some modifications. The reason trusts have always been such a popular tax planning tool is their ability to provide for children and other potentially vulnerable beneficiaries.
Trusts can be set up either during a person’s lifetime or under a will. The new rules mean that the majority of trusts will now be subject to the same IHT charging regime under which discretionary trusts have always operated. Prior to the Finance Act 2006, the inheritance tax rules distinguished between three types of trusts:
IIP Trusts (interest in possession trusts) are trusts where income is payable as of right to one or more persons for life or a specified period of time;
- A & M Trusts (accumulation and maintenance trusts) are trusts with some fairly tight rules set up for children or grandchildren who had to receive income by the age of 25; and
- 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 provides 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. Although there are a few transitional rules applicable to some existing trusts most will be subject to the discretionary trusts’ regime. The effects are outlined below.
Lifetime Trusts
IIP Trusts – Trusts set up before 22nd March 2006 are exempt from the changes unless the beneficiary changes after 6th April 2008. There are some exceptions for changes which occur before 6th April 2008 and for IIP Trusts for spouses where the spouse dies after that date. IIP Trusts set up after 22nd March 2006 will be subject to the discretionary trusts’ regime even if the spouse is entitled to the income.
A & M Trusts – The existing A & M Trusts regime will continue to apply to pre 22nd March 2006 A & M Trusts until 6th 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.
Discretionary Trusts – the existing discretionary trust rules apply to discretionary trusts whether created before or after 22nd March 2006.
Trusts created under a will
IIP Trusts – if death occurred before 22nd March 2006 the same rules apply to both IIP Trusts created under a will and to lifetime IIP Trusts. If death occurred after 22nd March 2006, such trusts are now known as Immediate Post-Death Interests (IPDI Trusts), and will be taxed as IIP Trusts under the pre-22nd March 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.
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.
Discretionary Trusts – the same rules apply to such trusts set up under wills both pre and post Finance Act 2006.
For more information, contact Charles McKenzie or John Rouse
