Trusting Trusts - I

RALPH RAY FTII, BSc(Econ), TEP, tax consultant, solicitor in Wilsons Solicitors, Salisbury looks at using and interpreting the right trust for particular tax planning circumstances.

(Statutory references are to the Inheritance Tax Act 1984 unless otherwise stated. The current nil rate band for 2002-2003 is £250,000.)

FROM A WIDE variety of trusts, this and the ensuing two articles concentrate on three species for the typical family business client to select: accumulation and maintenance; interest in possession; and discretionary trusts.

Three harmless varieties of trusts

In simple terms, a trust or settlement is a method of giving funds away, being an alternative to the outright, absolute gift. The donor or settlor creates the trust by giving property (the trust fund) to trustees (of whom he may be one), who hold the legal estate in a fiduciary capacity on behalf of the real, beneficial, persons entitled, namely the beneficiaries who may be named or ascertained by description.

Trusts have been used for many centuries, and for many reasons including:

• preservation of family assets down the generations;
• tax mitigation;
• charitable giving.

Trusts can be created during lifetime or by will, and can be far more flexible and useful than outright absolute gifts. As stated, in practice there are three main types of trusts as most commonly used by the family and/or business person.

Accumulation and maintenance trusts

The accumulation and maintenance trust within section 71 is for inheritance tax purposes the common or garden, parents' or grandparents' trust, and is favourably treated. Three basic conditions must be satisfied, namely that:

• one or more beneficiaries will become entitled to the capital or the income upon attaining the age of 25 years at the latest; and
• meanwhile no interest in possession subsists and the income is either accumulated or distributed for the maintenance, education or other benefit of one or more of the beneficiaries; and
• not more than 25 years have elapsed since the settlement was made; or alternatively all the beneficiaries have a common grandparent.

Given compliance with these conditions, transfers into the trust are potentially exempt transfers, and distributions to a beneficiary are exempt from inheritance tax during and on the termination of the trust. There are no ten-year anniversary or other charges such as apply to discretionary trusts (which will be analysed in the third article). Capital gains tax into and out of this and the other types of trust can in appropriate circumstances, or with appropriate assets, be held over - see sections 165 and 260, Taxation of Chargeable Gains Act 1992 (although note that there is no hold over possibility for non-agricultural land or a portfolio of quoted investments going into the trust). The intended wider relieving provisions for accumulation and maintenance trusts for holdover relief purposes in section 260(2)(d), Taxation of Chargeable Gains Act 1992 is restrictive, as the requirement is that the beneficiary becomes absolutely entitled during the lifetime of the trust and this applies relatively rarely in practice. Often in such trusts, the beneficiary only becomes entitled to the income by the specified age of 25, the capital being left in the flexible discretion of the trustees.

Extensive scope

Assuming that the three conditions of section 71, Inheritance Tax Act 1984 are satisfied, the general position is that once the assets have been placed into the accumulation and maintenance trust, no further inheritance tax is payable, i.e. the trust fund is inheritance tax-exempt. Moreover, when the assets go into such a trust, this constitutes a potentially exempt transfer and subject to the statutory conditions (see section 101 of, and Schedule 19 to, the Finance Act 1986) inheritance tax may be avoided or reduced. Since 10 March 1992, transfers of business or agricultural property into an accumulation and maintenance trust may be eligible for the 100 per cent or 50 per cent business relief (see Schedule 14 to the Finance (No 2) Act 1992). Thereafter, payment of distributions to a beneficiary in whole or part during or upon the termination of the trust do not give rise to an inheritance tax charge, for example when the beneficiary becomes entitled to, or to an interest in possession in, the trust fund on or before the specified age, or the death of a beneficiary before attaining the specified age. No ten-yearly or interim charge arises because the accumulation and maintenance trust is not subject to the discretionary trust régime, not being 'relevant property'.

Accordingly, the use of an accumulation and maintenance trust has become fashionable in many circumstances, for example:

• as a potentially exempt transfer gift; or gift of business or agricultural property eligible for the 100 per cent or 50 per cent relief given under Schedule 14 to the Finance (No 2) Act 1992;
• by way of a trust bust operation; this is particularly suitable for a discretionary trust of the nil band before the first or next relevant ten-year anniversary of the trust;
• as a capital tax-free fund, for example, for private company shares, or land;
• as a vehicle for death in service capital sums in an occupational pension scheme for a deceased working director who has nominated his children. The trustees might then use this liquid fund to buy other (illiquid) assets from the deceased's widow;
• to hold appropriate life policies;
• as a harmless type of will trust, e.g. for grandchildren of the testator/testatrix.

Accumulation and maintenance trusts were introduced by a former Labour Government in the mid-1970s, and are therefore likely to continue to be treated reasonably favourably.

Extra flexibility

For inheritance tax, the flexible accumulation and maintenance trust can introduce an appointed class after interests in possession have arisen, yet originally within section 71. For example, in relation to a grandparents' accumulation and maintenance trust, once the grandchildren have respectively attained the vesting age, and thus their entitlement to income, such entitlement could be revoked in whole or part and a so-called 'appointed class' defined in the deed could become eligible in the trustees' discretion. The beneficiaries of such appointed class would not have to be under the age of 25, because they can only benefit once a grandchild has attained an interest in possession (which is itself treated as a potentially exempt transfer), and the provisions of section 71 as to the accumulation and maintenance régime are therefore not breached.

Avoiding capital gains tax problems

When assets leave an accumulation and maintenance trust, for example on winding up the trust or advancements to beneficiaries, capital gains tax holdover relief applies if the assets are within section 165, Taxation of Chargeable Gains Act 1992. Non-business or agricultural assets, that is, investments for occasions on which a beneficiary becomes beneficially and absolutely entitled to trust assets held on accumulation and maintenance trust, can be held over under section 260(2)(d), Taxation of Chargeable Gains Act 1992, if the entitlement arises at a time when no interest in possession exists. Unfortunately this is of limited use, because most modern flexible type accumulation and maintenance trusts only provide that the beneficiary becomes entitled to income at the specified age, and not capital which remains in the trustees' discretion.

Alternatively, the problem arises because the beneficiary's capital entitlement may be held for him at, say, 21 or 25, and under section 31, Trustee Act 1925 the beneficiary would have been entitled to an interest in possession from age 18. This problem can be overcome by excluding section 31.

The capital gains tax holdover problem exists because the beneficiary does not become entitled to the capital and income at the same time and therefore section 260(2)(d) is not satisfied.

Possible solutions

It may be possible to advance the capital at the same time or before entitlement to income arises, thereby satisfying section 260(2)(d), Taxation of Chargeable Gains Act 1992.

Alternatively, the beneficiary of the trust as settlor could settle or assign as from an 'effective date' (and without apportionment) all his income interest under the trust to be held by the trustees on new trusts. Such income interest under the new trust is on accumulation and maintenance trust terms, with powers of accumulation and/or maintenance, etc. From the date on which it is intended that the beneficiary is to receive the capital, this new trust collapses so that the accumulation and maintenance régime ceases and the beneficiary becomes entitled to the capital and income at the same time. Therefore section 260(2)(d), Taxation of Chargeable Gains Act 1992 is satisfied and the holdover claim is available. The assignment of the interest in possession is not a capital gains tax disposal, being an assignment of an interest in income only.

25-year time limit trap

There is no limit on the duration of an accumulation and maintenance trust if all the beneficiaries are grandchildren of a common grandparent (or children, widows or widowers of such grandchildren who were beneficiaries but have died before becoming entitled); see section 71(2), Inheritance Tax Act 1984. Where the common grandparent condition is not satisfied, a trust can only qualify as an accumulation and maintenance settlement for 25 years from its commencement (or from 15 April 1976 if later). If the 25-year limit applies to the trust and is allowed to run out, there will be a charge to inheritance tax on the value of the trust property. This charge will be at the flat rate of 21 per cent under section 70(6). The tax would only have to be grossed up if the tax were paid out of a trust fund which had not ceased to be within the accumulation and maintenance trust régime under section 71 after the chargeable event, and this is an unlikely situation. The inclusion of a 'peg leg' beneficiary of convenience to satisfy section 71(7) may itself breach the common grandparent requirement, even if excluded at some stage after the commencement of the trust.

The 25-year period is counted from the commencement of the settlement, or from the date it qualified as an accumulation and maintenance settlement, or from 15 April 1976, whichever is the later date. It follows that the first time this charge could arise was 15 April 2001. It will be important for practitioners and trustees to consider any accumulation and maintenance settlements which are approaching their 25-year life span, and ensure that qualifying beneficiaries are given an interest in the property before the time limit expires. The interest given may either be an interest in possession in the property or an absolute interest in the capital. There is no problem if all the beneficiaries have already received a right to income, because the settlement will then have ceased to qualify as an accumulation and maintenance settlement. Readers are referred to Peter Assheton's article, 'Hitting the Buffers', in Taxation, 7 September 2000 at pages 588 to 589 for coverage of this subject.

Precedent analysis

The Butterworths Encyclopaedia of Forms and Precedents 2002, fifth edition reissue volume 40(2) contains a wide and useful selection of accumulation and maintenance trust precedents, in particular:

• Form 480 - short form, a simple but not very flexible form, e.g. vesting at age (say) 35.
• Form 481 - long form with differing entitlement to income and capital, accumulations, overriding power of advancement ultimate trust, provisions as to trustees including charging, protection, appointment; exclusion of settlor and spouse, administrative provisions.
• Form 482 - a further fully flexible form.

Volume 40(1) contains Form 2 - a checklist before drafting; and Form 3 - the STEP standard administrative provisions.

Issue: 3881 / Categories: