Trusting Trusts - III

RALPH RAY FTII, BSc(Econ), TEP, solicitor, consultant with Wilsons concludes his series with an examination of discretionary trusts.

Statutory references are to the Inheritance Tax Act 1984 unless otherwise stated.

IN 1982 A new discretionary trust régime was introduced (see sections 58 et seq). This was less onerous than the previous one, although it should be remembered that transfers into these trusts and out of them are outside the potentially exempt transfer régime. The charge during the life of the trust centres on the ten-yearly anniversary charge of 30 per cent of the lifetime rate; this constitutes a manageable maximum of six per cent (30 per cent x 20 per cent), or if 100 per cent business property or agricultural property relief is applicable, no liability should exist, and three per cent if 50 per cent business or agricultural property exists. The ten-year period is divided into 40 separate quarters, and no charge accrues in respect of any quarter within the ten-year cycle during which the property in question was outside the discretionary trust régime. In addition, there is a proportionate exit charge when property leaves a discretionary trust during the ten-year period, again calculated on a quarterly basis, at the rate charged at the previous ten-year charge.

An estate owner and spouse might each consider creating a discretionary trust within the nil rate band value. No inheritance tax can then arise until the first ten-year anniversary (subject to any aggregation with the settlor's chargeable gifts). Moreover, if the trust fund, or any part thereof, is extracted from the trust before the ten-year anniversary, there would be no exit charge, however much the asset has increased in value, because one looks back to the commencement of the ten-year period at which, by definition, the trust fund was within the nil rate band. Subject to certain safeguards, the estate owner's spouse might be included as one of the discretionary beneficiaries with no inheritance tax disadvantage, although income and gains would then continue to be taxed on the settlors.

The discretionary trust is undoubtedly the most flexible form that exists, its main disadvantage being that transfers into such trusts are chargeable transfers and not potentially exempt transfers. As a corresponding advantage, for capital gains tax, holdover relief into and out of such trusts is available for all (including investment) assets.

Second home

A particular use for discretionary trusts could be for second homes following the holdover restrictions in sections 165 and 260, Taxation of Chargeable Gains Act 1992. The following example demonstrates how.

Father (and mother) transfer a second home into two discretionary trusts in respect of which the son is a potential beneficiary among others. Holdover relief is available and no inheritance tax should be payable because one (or two) nil rate bands are available.

The trustees allow or entitle the son to occupy this home as his main residence; but only after the discretionary trust has been established. It is suggested that the discretionary régime subsists for, say, six months, preferably straddling a tax year. During this period some income should arise and be subject to the trustees' discretion, and for this purpose the settlors could also settle some cash. Also in this period, the son referred to could occupy under a non-exclusive licence. When appropriate, the trustees could then sign a resolution entitling the intended beneficiary to occupy, or make a revocable variation by way of interest in possession to that beneficiary.

If the intended beneficiary is already in occupation at inception, the plan should work provided that he has no rights or entitlement to occupy until a later stage.

Subsequently, on a sale by the trustees, the main residence exemption is available under section 225, Taxation of Chargeable Gains Act 1992 (see also Sansom v Peay [1976] STC 494). Alternatively, if the trustees advance the house to the son, and he sells it, the capital gains tax exemption applies under section 222, Taxation of Chargeable Gains Act 1992. During the 36 months preceding a disposal of the home, the main residence exemption can still apply even though it is not occupied during that period: see section 223(2).

This method of interposing a discretionary trust could be adapted for other investments, for instance quoted shares and heirloom chattels.

The settlor's spouse can be a beneficiary, in which case there is no gift with reservation, but the settlor's spouse must not benefit indirectly.

The trustees could transfer out the house or other investments to, say, six beneficiaries. The trustees elect for capital gains tax holdover under section 260, Taxation of Chargeable Gains Act 1992. Provided that they are operating within the nil rate band, there is no inheritance tax and the six beneficiaries may each have his capital gains tax annual allowance. For 2002-03 the allowance is £7,700, so the potential capital gains tax saving is up to £18,480.

Flexible discretionary trust

In order to deal with high value investment type assets pregnant with capital gain, where it is not possible to hold over the capital gains tax under section 165, Taxation of Chargeable Gains Act 1992 because they are not business assets, a flexible discretionary type trust used to be suggested. This may still be viable. This discretionary trust would, after a minimum of three months, terminate initially on to interest in possession trusts for the client settlor and then subsequently a further interest in possession or accumulation and maintenance trust for, say, his children or grandchildren from which he and his spouse would be excluded. Within the interest in possession period, there would be a time during which the settlor could claim back the trust fund or a part, or alternatively he would have retained other interests. The settlor's retained interests would be so substantial that there should be little loss to his estate for inheritance tax purposes.

It would, therefore, be an appropriate way of channelling assets to the children, minimising the payment of capital gains tax and inheritance tax.

This arrangement was likely to succeed in the light of the High Court's decision in Melville v Commissioners of Inland Revenue [2000] STC 628 and later the Court of Appeal's decision [2001] STC 1271 because the settlor's power to recover was property of the settlor which remianed in his estate following the transfer into the discretionary trust.

The three judges in the Court of Appeal unanimously supported the High Court decision in favour of the taxpayer.

This important victory for the taxpayer was, however, a loophole and was closed by anti-avoidance legislation in section 119, Finance Act 2002. The new rule provides that, as from 17 April 2002, powers, such as a general power of appointment reserved to the settlor, does not reduce the value of the settlor's transfer of value into the trust.

The remaining alternatives to the settlor retaining a general power of appointment are the following:

• After an initial period of, say, 90 days minimum, the settlor has an interest in the trust which he may assign. During this period, the discretionary trust subsists. Such an interest could constitute a revocable, assignable life interest. If the settlor is elderly, the adviser should consider including a fixed income interest for, say, 50 or 60 years which could accrue to his estate, the purpose being that this retained interest has substantial value in the context of reducing the settlor's transfer of value into the discretionary trust.
• Alternatively, the retained interest might be an assignable reversionary interest, after the initial 90-day period. Again, the settlor may decide to give away this reversionary interest.

Ten-year bonanza

As regards the ten-year anniversary charge for discretionary trusts, the inheritance tax rate by reference to the initial value of the settled property at the start of the ten-year period continues throughout the period, that is until shortly before the first or next ten-year anniversary. This gives rise to tremendous opportunities for inheritance tax planning, as illustrated in Example 1.

Example 1

Business assets

The transfer of business assets into such flexible trusts during lifetime or by will should undoubtedly prove among the best estate planning methods available: see Example 2. In particular, certain business and agricultural assets can be held in such trusts indefinitely with 100 per cent relief and will not be chargeable at the ten-year anniversary dates nor any interim charges after the first ten-year anniversary charge. At the ten-year anniversary, the trustees will need to satisfy the relevant business or agricultural property conditions. Assuming that the 100 per cent relief applies (and any other assets in the trust are within the nil rate band), the ten-year anniversary charge rate will be zero, and that zero rate will apply until immediately prior to the next ten-year anniversary, even though the assets are no longer business or agricultural assets, as for example will be the case where the trust fund consists of the proceeds of sale.

Example 2

An existing trap for the unwary remains relevant for the 50 per cent, but not the 100 per cent, relief. Under section 68(4) and (5), Inheritance Tax Act 1984, in arriving at the rate of interim charges before the first ten-year anniversary (but not otherwise), no allowance is made for any business or agricultural relief at the 50 per cent rate. As to the 100 per cent relief, the risk seems to have disappeared because the value of the asset for section 68 purposes is zero, and therefore there is no charge.

For lifetime discretionary trusts, there is no capital gains tax holdover relief restriction in connection with non-business assets: see section 260, Taxation of Chargeable Gains Act 1992 (although there may be an inheritance tax restriction in respect of 'excepted' assets under section 112, Inheritance Tax Act 1984).

A double relief

An inheritance tax saving is possible in discretionary trusts using agricultural property relief and business property relief. In essence, it works along the following lines.

Spouse 1 (H) in his will leaves business or agricultural property (plus the nil rate band sum) to a discretionary trust in favour of the family including spouse 2 (W). On H's death, business property relief and agricultural property relief is obtained for the first time. The capital gains tax death exemption and market value uplift also applies for the first time: see section 62, Taxation of Chargeable Gains Act 1992.

H leaves W his investment assets or she owns such assets in her own right.

W purchases at arm's length, for instance under a market value option granted to her in H's will, the business and agricultural assets from the trustees.

On W's death after two years from the purchase, her estate should also be eligible for the relief a second time. Likewise the capital gains tax death exemption and market value uplift should apply. Further details of this strategy can be found in Richard Kirby and John Liddington's article 'What a Relief' in Taxation, 25 March 1993 at pages 583 to 584, and Example 3 illustrates the possibilities.

Example 3

Mini discretionary will trust

Discretionary trusts can also be used to enable a surviving spouse to enjoy the benefit of a fund without the penalty of wasting the nil rate band. Under this method, a discretionary trust of the nil rate band could be used, the distributions from which to the surviving spouse would only be used in cases of need. For example, assume that a husband and wife each have an estate of £500,000; and that the husband dies first wishing his widow to be the primary beneficiary. Under a commonly used, but wasteful alternative, the husband could give his widow his £500,000 estate (absolutely or by way of life interest) ensuring that no inheritance tax was payable on his death. On her death, however, having regard to the bunching effect, inheritance tax would be payable on an estate of £1 million (£300,000 inheritance tax in 2002-03).

A more sophisticated plan would be for the husband to give his widow only £250,000 and settle the remaining £250,000, i.e., the 2002-03 nil rate band, on discretionary trusts, with informal directions to the trustees to treat the widow as the principal beneficiary. So, if she were in need, the trustees could make:

• a capital distribution; or,
• perhaps, more appropriately, a loan which should be a deduction from her estate on her death (but watch section 103, Finance Act 1986, especially if there have been lifetime gifts from her to husband); or
• income distributions.

The inheritance tax at 2002-2003 rates would therefore be reduced to £200,000 on the widow's estate of £750,000, and with the discretionary trust fund bring within the nil rate band on the husband's death. There would be an inheritance tax saving under this alternative of £100,000 (£300,000 - £200,000).

This is regarded as one of the most effective, yet simple, inheritance tax savings that can be introduced in a will. There are, however, possible danger areas to be borne in mind:

• Related settlements (section 62). The value of the other property settled by the will (i.e. the related settlement(s)) could form part of the cumulative total of transfers which are inherited for evermore by the discretionary will trust. The use of a 'pilot' lifetime trust can provide the solution.
• If the discretionary trust continues for more than ten years, the inheritance tax ten-year anniversary and interim charges may accrue (sections 64 to 69).
• Inheritance tax distributions out of the trust would not be as legatee with the relief afforded under section 62(4), Taxation of Chargeable Gains Act 1992, but instead a distribution as trustees.
• Inheritance tax distributions to the widow(er) should not normally be made within three months of the death (section 65(4)). See Frankland v Commissioners of Inland Revenue [1997] STC 1450 and Harding and Leigh (Loveday's executors) v Commissioners of Inland Revenue SpC 140.
• No capital gains tax holdover relief can be claimed under section 260, Taxation of Chargeable Gains Act 1992 in the two year period from death. The same applies to appointments within three months after creation or any anniversary charges.
• There is no capital gains tax uplift on death of a beneficiary. This contrasts with the position where a beneficiary has been given the asset absolutely and died owning it, although this is then subject to inheritance tax.
• From 6 April 1999, discretionary trusts can pay income tax at 43 per cent (or more) on dividends. This results from the effective withdrawal of the tax credit when trustees distribute the income from the trust to beneficiaries.

Home loan/charging method

If the home is the main asset in the estate of the first spouse to die, say the husband, he could gift the nil rate band in his will as a monetary legacy to chargeable parties by use of a mini discretionary trust, so as not to waste the nil rate band. The residue, in particular the home, is left to the widow. The nil rate band gift would be satisfied by a loan or charge on the property in favour of the trustees of the mini discretionary trust who are likely also to be the executor/trustees of the will. That loan/charge could be on favourable terms for the widow, e.g. free of interest and deferred as to payment of the capital, albeit preferably, payable on demand by the trustees. The loan/charge should then be a deduction from the widow's estate on her death, subject to a possible disallowance if the wife had made lifetime gifts of substance to her husband: see section 103, Finance Act 1986. In that event, the widow could be given only a life interest, with the trustees of the discretionary trust taking the charge or loan from the trustees of the life interest trust; or the personal representatives could create the charge before appropriating the home to the widow out of residue.

The widow would have had use and occupation meanwhile. It is important that the trustees should be specifically authorised in the will to allow the charge to be free of interest and to defer calling in the capital, i.e. permitting the payment of the legacy of the discretionary trust to be deferred, notwithstanding that one of the trustees is the beneficiary of the home. This arrangement is generally accepted by the Capital Taxes Office.

Post spring Budget 2003 hedge

Using multiple discretionary trusts to maximise the nil rate bands, taken at £250,000, the following arrangement can be adopted where 100 per cent business property relief or agricultural property relief applies.

Assume such business or agricultural assets are worth £1,500,000. The estate owner creates six discretionary trusts at staggered intervals each including £250,000 of such assets. The result would be no inheritance tax liability on the transfer into the trusts because the 100 per cent relief applies; and capital gains can be held over, at the expense of taper relief. Each trust should be protected by the nil rate band rule even if the 100 per cent business property relief and agricultural property relief rules are altered in the future; and even if the assets cease to be such assets.

In this respect, the Special Commissioners' decision should be noted in Rysaffe Trustee Co (CI) Ltd SpC 290. Five separate settlements on the same terms were created on different dates, and at the ten-year anniversary the Revenue's contention of only a single settlement existing, by associated operations, was upheld so that only one nil rate band was available. However, the taxpayer's appeal in the High Court succeeded [2002] STC 872. On the evidence, five separate settlements were clearly intended; and the section 268 'associated operations' provision was not an operative rule; it merely defined the term 'associated operations'.

Precedent analysis

Butterworths Encyclopaedia of Forms and Precedents Fifth Edition 2001 Reissue Volume 40(1) contains a wide and useful selection of discretionary trust precedents and analysis, in particular:

Form 4 [paragraphs 1081 - 1106] containing principal trusts of income and capital, ultimate trusts, provisions as to beneficiaries including alterations, administrative provisions, and appropriate arrangements as to the trustees, e.g. charging, protection, appointment, investment, etc.

Issue: 3883 / Categories: