Select Committee on Treasury Written Evidence

Memorandum submitted by the Law Society


  BN25 headed "aligning the inheritance tax treatment for trusts" contains some entirely unexpected changes in the way the inheritance tax regime applies to trusts.

  The Chancellor has introduced measures that, will give rise to a number of issues, including:

    —  taxpayers with assets in excess of the Nil Rate Band will have to review their wills and in many cases change them to probably a less flexible structure. They may not be capable of doing so—the elderly and those covered by the Mental Health Act, who may not have the requisite mental capacity to change their wills, may be prejudiced;

    —  all divorced wives and children with existing court orders establishing trusts in their favour will need to take advice, which in many cases is likely to involve the need to make expensive court applications to rectify the traditional, legal planning;

    —  all who have recovered damages (eg personal injury, criminal injuries compensation) that have been placed in trust may also be affected;

    —  additional hurdles for those wishing to protect their children against the risk that a surviving spouse (especially in second marriages) will defeat their interests;

    —  parents will have to leave assets to their children at an age which may be in individual circumstances inappropriate because of the maturity of the beneficiary, (for example, settlements for children who have difficulties coping with the world at large and their financial affairs but whose parents would baulk at the thought of having to claim that the child was disabled within the section 89 IHTA and Mental Health Act definitions); and

    —  anyone proposing to leave assets on modern protective (essentially anti-bankruptcy) trusts[34] will either have to put the family's entire wealth at risk of creditor claims or to leave a surviving spouse destitute to protect the children. This will particularly impact on Lloyd's members and the self-employed.

  There is the additional issue that it is not clear for inheritance tax purposes which trusts fall within the definition of settlement and whether IHT extends to commercial trusts. The intended changes have a potentially far reaching effect as a result.


  1.  BN25 does not indicate what mischief it is aimed at addressing, yet the manner of its introduction would suggest it is seen as an anti-avoidance measure: there is a reference on page 118 of HC 968 issued by the Treasury with the Budget papers (at para 5.102) which refers to "preventing these trusts from being used to shelter wealth from inheritance tax". As discussed below, trusts of any substance are of dubious tax advantage and generally neutral; furthermore, they have some fundamental and unobjectionable non-tax objectives which will now become prohibitively expensive. In our view, there is no tax-avoidance special status of trusts.

  2.  Trust structures either made in lifetime or on death are typically used for a variety of non-tax reasons and are largely tax neutral. Some of the reasons are:

    —  concentration of assets for management reasons;

    —  the protection of family assets from the impact of a divorce in future generations. Any abuses of this are already easily tackled by the divorce courts;

    —  the laudable and responsible objective of protection of vulnerable beneficiaries, who under the historic regime have been the deemed owners for tax purposes and therefore subject to inheritance tax, but have been insulated from spendthrift behaviour and protected from creditor claims which might make them a burden on the State; and

    —  the protection of first families where there has been a second or subsequent marriage—again this typically has no greater tax benefits than handing over the assets outright, but in a country which has in most cases no automatic succession rights for children, this means they can still inherit family money, while at the same time the surviving spouse is looked after.

  3.  A common use of accumulation and maintenance trusts is as school fees planning vehicles: an earlier generation sets aside funds for the maintenance of children/grandchildren, who pay their own fees through the trust, to the advantage of the Treasury in two ways. First there is the risk (as with an outright gift—which you would not make to a minor) of the donor not surviving seven years, which yields an inheritance tax charge. Second, the trustees, parents or children pay income tax and capital gains tax at normal rates on income and gains, though note that trusts have a reduced gains tax allowance (which makes trusts marginally less attractive in pure tax terms than outright ownership.

  4.  The original rationale for the discretionary charge regime was to ensure that there was no loss of revenue in a trust where the assets would never otherwise be deemed to be part of a taxpayer's estate. The idea has traditionally been explained to be that the charge on the way in and the periodic 6% charges on exits of assets or at least on 10-year anniversaries was designed to ensure the equivalent of a once a generation (approximately every 30 years) full charge to inheritance tax at 40% (which you have the same chance of getting in a life interest trust as with outright ownership). In the case of life interest trusts or of most A & M trusts (which mostly metamorphose into life interest trusts), either (a) the potentially exempt charge regime applies and the Treasury sees tax on a donor or beneficiary not surviving seven years or (b) the donor or beneficiary survives legitimately and the Treasury has the same chance of seeing tax in relation to the recipient's estate as it did in relation to the donor or (c) the Treasury sees the tax on the life tenant's death because he hasn't tried to avail himself of the potentially exempt charge regime in favour of the next rank of beneficiary.

  5.  Significant problems are likely to arise with reducing the age at which beneficiaries must acquire assets to 18. Most agree that an 18-year old is still young and lacking experience, while a 21-year old has at least some experience. By 25, children have had the opportunity to join the job market and establish themselves and prove their ability to manage money.

  6.  The reasons why testators or settlors choose a vesting age over 18 include:

    —  to allow the child time to make a will, to avoid the inheritance passing under the intestacy rules back to an absent, estranged, unknown, unsuitable, incapable, imprisoned, improvident or immensely rich surviving parent or on to an absent, estranged, unknown, unsuitable, incapable, imprisoned, improvident or immensely rich sibling, or an aged, absent, estranged, unknown, unsuitable, incapable, imprisoned, improvident or immensely rich grandparent;

    —  so that the first child to reach 18 cannot insist on the house being sold to get their share, resulting in younger siblings being made homeless;

    —  to ensure that a surviving parent remains responsible for maintenance until the child leaves fulltime education;

    —  to ensure that a child has sufficient maturity to resist pressure to hand money over to an improvident parent, sibling or spouse; and

    —  to allow the trustees the flexibility to put younger children through university, in addition to their share of the estate rather than out of their share, so that younger children are not prejudiced by the fact their parents have died before they graduated.

  7.  These changes made by BN25 run contrary to the Revenue's avowed intent (expressed in the consultation process which has led to the reform of the tax treatment of trusts for capital gains and income tax purposes) to create "a tax system for trusts that does not provide artificial incentives to set up a trust but, equally, avoids artificial obstacles to using trusts where they would bring significant non-tax benefits".

  8.  Until enactment of the Finance Bill (whose publication date is not known), it is not clear what steps should be taken by taxpayers in relation to their wills, done under the old, tried and tested system: a taxpayer who dies in the limbo period may find there is no spouse exemption available for his surviving spouse and a cut in the children's inheritance. Civil partners, new to this regime, will also be hit.


  The following is a brief summary of the existing (pre-22 March 2006) treatment of trusts.


  At present, where the terms of a trust provide that an individual is entitled to the income of the trust property (an "interest in possession trust") the inheritance tax treatment of that individual (the "Life Tenant") is as follows:

    —  the Life Tenant is treated as the owner of the underlying trust assets for inheritance tax purposes;

    —  if the Life Tenant dies the trust property will be included in his estate (and taxed accordingly); and

    —  if his interest is terminated during his lifetime, he will be treated as making a gift of the trust property; if the property passes outright to another individual or continues to be held on interest in possession trust for another individual, tax will only be payable if the Life Tenant (as donor) fails to survive the termination of his interest by seven years (this is a potentially exempt transfer) always assuming no other exemptions are available (such as the spouse exemption).

  A gift into an interest in possession trust is treated in the same way as a gift to another individual—so where an interest in possession trust is created by an individual during his lifetime inheritance tax will only be payable if he fails to survive the gift by seven years. If the donor fails to survive, the fact that the property is in trust confers no benefit. If the donor does survive, the trust is no better off than if the donee had been an individual. The assets in the trust are expressly deemed to form part of the donee Life Tenant's estate and tax will be due on the same basis as described above on any gifts by the Life Tenant.


  Very different rules apply to trusts under which no individual is entitled to the income of the trust property—ie a trust under which distributions of income and capital are made at the discretion of the trustee (commonly referred to as "discretionary trusts").

    —  A transfer of assets into a discretionary trust results in an immediate inheritance tax charge for the settlor at 20% (insofar as the value transferred exceeds the settlor's available nil-rate band) with additional tax chargeable if the settlor dies within seven years.

    —  During the life of the trust, periodic inheritance tax charges are imposed every 10 years at a rate of 6% on the value of the trust assets insofar as they exceed the inheritance tax threshold.

    —  An exit charge is payable when capital is distributed from the trust at any stage between 10-year anniversaries (basically a fraction of the 10-yearly charge apportioned by reference to the time which has passed since the last 10-year anniversary).


  The discretionary trust charging regime does not apply to children's "accumulation and maintenance" trusts (aka A & M trusts), which in many ways are hybrids of discretionary and life interest trusts. These are (broadly speaking) trusts under which:

    —  the beneficiaries (normally grandchildren of a common grandparent) will become entitled either to the trust property itself or to its income;

    —  on or before attaining an age not exceeding 25 (typical ages are 18, 21, 23 and 25);

    —  the trust income is to be accumulated (ie added to capital) insofar as it is not used for the maintenance, education or benefit of any of the beneficiaries.

  Although without trustee action no individual will be entitled to the income of property held on A & M trusts (at least until the beneficiaries attain the relevant age), so that an A & M trust is indistinguishable in practice from a discretionary trust while the children are under the relevant age, the discretionary trust charging provisions described above are suspended; there are no periodic or exit charges. Furthermore, a gift into an A & M trust is a potentially exempt transfer which will not be chargeable if the creator survives by seven years.

  Discretionary trusts offer a great deal of flexibility in terms of how the trust property is distributed; however the inheritance tax treatment described above makes them relatively unattractive in many cases.

  By contrast, interest in possession and A & M trusts have been commonly created in lifetime and on death (by the inclusion of suitably drafted trusts in wills). Both forms of trust allow assets to be made available for the benefit of children or other dependents without handing over direct control of these assets to them. The current regime has been in place for over 20 years and is well understood and accepted by taxpayers and their advisers.

  The changes proposed are far reaching and will have significant impact on existing trusts. Given the breadth of inheritance tax the changes could also affect trusts established for commercial purposes which may not fit within the existing narrow IHT exemptions. It is considered that the start date of the legislation should be postponed and safe harbours consulted upon.

27 March 2006

34   Protective trusts typically exist under section 33 Trustee Act 1925, although their pedigree is older. They are life interest trusts under which the life tenant has the right to income/enjoyment of the assets, but in the event he attempts to deal with the life interest, eg by assigning the benefit of it to creditors or by trying to give up part or all in favour of the next rank of beneficiaries, the interest evaporates. A discretionary trust over income arises. Under the "old" rules, it had no tax advantage as the assets would be taxed on the life tenant's death (having possibly also suffered a charge on creation) and the life tenant paid income tax each year. They have typically been used by the spouses of the self-employed and investors in Lloyd's of London, to try to guard half the family wealth against potential creditor claims against their spouses (to the benefit of the state and the succeeding generation). Back

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