Techzone

It’s a little more than 20 years since Chancellor Gordon Brown announced one of the most far-reaching changes to the taxation of trusts. It was a move that would see virtually all new trusts created after 22 March 2006 subject to relevant property regime, with only a few exceptions. This potentially means a 20% IHT charge on entry, plus 10-yearly periodic charges and exit charges when capital is paid to a beneficiary.

This resulted in a shift in behaviour with many individuals capping the amount gifted to their available nil rate band to avoid a 20% tax charge on trust creation. Fast forward 20 years and trusts set up in the immediate aftermath will be approaching their second 10-year anniversary. And given that the IHT nil rate band has been frozen for 17 of those 20 years that could mean that tax is now due. 

The 10-yearly charge

In simple terms the IHT charge at each 10-year anniversary is 6% on the value of the trust over the trust’s nil rate band. However, the steps taken to reach this point can be a little more complex.

Step 1 – Value the trust, “the notional transfer”
The first step is to determine the value of the trust assets at the 10-year point. For a gift trust obtaining trust values should be straightforward. The notional transfer will normally equal the value of the trust asset – so if that asset is an investment bond the transfer value will be the surrender value.  

The value for a loan trust will also be relatively easy. The notional value transferred is the value of the investment bond less the outstanding loan owed to the settlor. 

Discounted gift trusts are harder to value. The market value is the amount a hypothetical purchaser would pay for the trust fund bearing in mind that the settlor will continue to receive their regular payments and the purchaser would not receive anything until after the settlor’s death. This will typically require an actuarial calculation. However, the product provider may be able to provide support with the valuation for the 10 yearly charge that is acceptable to HMRC.

Also included at this step is the value of any related settlements. That is the initial value of any trusts created by the settlor on the same day as the trust in question.

Step 2 – Calculate the available nil rate band
The next step is to calculate the trust’s available nil rate band. This is the prevailing nil rate band at the anniversary date, less the value of any other chargeable lifetime transfers (CLTs) the settlor made in the seven years before the trust was created. Also deducted are any capital payments made by trustees to a beneficiary, or ‘exits,’ in the last 10 years.

Step 3 – Determine if tax may be due
If the trust value at the anniversary is less than the available nil rate band there will be no periodic charge. However, even if no tax is payable, it may still need to be reported to HMRC if the trust value is greater than 80% of the nil rate band, currently £260,000. For loan trusts this is the value before deduction of the outstanding loan.

Step 4 – Calculate the tax
While the tax charge is often summarised as 6% on the excess above the nil rate band, it's a more complicated multi-step process to arrive at the actual charge. Firstly, the excess over the available nil rate band is multiplied by the lifetime IHT rate of 20% to determine the notional tax due. This is then divided by the trust value from Step 1 above to arrive at the effective rate of tax. The actual rate used at the 10-year anniversary is 30% of the effective rate – hence why it's typically summarised as 6% (30% of 20%) of the excess.

This rate is then applied the value of the trust assets at the anniversary date (but excluding the value of related settlements) to determine the final tax liability. 

Exit charges

A charge at each 10-year anniversary isn’t the only tax trustees need to mindful of. There may also be tax to pay when trustees pay capital to a beneficiary. The rate of tax applied to the capital leaving the trust follows the same methodology as the calculation at the 10-year point but using the nil rate band in the tax year of the exit. 

If capital is appointed to a beneficiary before the first 10-year anniversary, the rate is calculated on a notional chargeable transfer of the trust assets immediately after they entered the trust. The effective rate is calculated based on notional tax charge of 30% of lifetime rate of 20%, even if the trust was created on death.

In both cases the rate is then proportionately reduced based on the number of three-month periods (quarters) which have elapsed since the last 10-year anniversary or inception of the trust. As a rule of thumb, if no tax was due on creation of the trust, there's normally no IHT due on any distributions made in the first 10 years. However, there are some exceptions to that rule:

• Where the settlor dies and there’s a failed PET in the seven years before the trust was created
• Where an exemption, such as gifts from surplus income, resulted in no IHT on the gift into trust
• Where the gift into trust was an asset that benefited from business or agricultural relief and no longer qualifies for relief or has been disposed of

A special rule also applies in the case of a discretionary will trust so that there will be no IHT exit charge on distributions within two years of the settlor's death. Instead, it's treated for IHT as having been made by the deceased at the time of their death.

Appointing capital to reduce the periodic charge

Trustees facing a tax charge at their next 10-year anniversary may want to consider whether it's the right time to distribute capital to the beneficiaries. This can be a tax efficient way to extract capital from the trust especially if there was no tax due at the last periodic charge date or when the trust was created. But it's equally important to ensure the intended purpose of the trust isn’t sacrificed in the pursuit of saving tax.

If it isn’t appropriate to pay out the whole trust, a distribution of just part of the capital can still reduce the periodic charge. The amount distributed to the beneficiary is included in the calculation to determine the rate of tax payable on the assets in the trust at the anniversary date. So, while the rate of tax at the anniversary date isn’t reduced by the exit, the value of trust assets to which it applies has reduced.

It should also be remembered that the calculation deals with exits made in the previous 10 years by reducing the available NRB at the periodic charge date, and not by adding them back to the value of trust assets before deducting the NRB. Once the NRB has been reduced to zero, the value of any additional exits will not further increase the actual rate applied at the 10-year anniversary, resulting in a smaller periodic charge. This additionally means that the rate applied to exits in the next 10-year period will be less. 

For those trustees that just missed the opportunity to make exits prior to the anniversary date, there is a small window of opportunity to distribute capital free of IHT. Any exits made in the three months following a 10-year anniversary will not attract an exit charge.

Reporting and paying IHT

Any IHT on a 10-year anniversary or exit must be paid and reported within six months from the end of month in which it occurred. Reporting may still be required even if no tax is due. If the notional transfer calculated at Step 1 is more than 80% of the nil rate band, the trustees will need to submit an IHT100d to HMRC. This figure excludes any business or agricultural relief and, for a loan trust, it ignores any deduction for the outstanding loan.

It's worth remembering that trusts which registered as a non-taxable express trust on the UK TRS will need to update the registration to a taxable trust once IHT becomes payable. 

Further details of periodic and exit charges can be found in our technical guide 'Discretionary Trusts'.

Summary

Complex IHT charges and reporting obligations may seem off-putting for some clients, but the IHT savings and control trusts can provide more than outweigh any perceived barriers. With pensions forming part of the estate from next April, the use of trusts as a means of tax effective wealth transfer is only set to grow.