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I HAVE YET to catch up with iPods, rewritable DVDs and eBay, but I have at least arrived in the world of Sudoku. Even more scintillating than that is the fact that I first wrote about reverter to settlor trusts as far back as five years ago, long before they were flavour of the month. How cool can you get! So would all of those sniggering at my luddite tendencies think again, please, and I will get into Sat Nav and Bluetooth as soon as I can.
An update
If times were supposed to be a' changing when Bob Dylan wrote his famous hit in the mid 1960s, all one can say is that he had not seen anything like that which we have to cope with now. Just transporting Tolley's Tax Handbooks from one's desk to the office meeting room constitutes a severe health and safety risk and yet draft tax law rewrite Bills are still appearing faster than I can click my computer mouse.
So it is no surprise that, since my article, 'Back to square one', on reverter to settlor trusts in Taxation, 12 October 2000, page 42, so much has changed that it looks to be high time for the subject to be revisited, particularly in the context of the current popularity of these devices.
What are they?
To begin at the best place, which is the beginning, the trusts I am considering here are those where the settlor retains a reversionary interest. Funds will be placed into trust for the benefit of another person, and on that person's death, the settlor will be due to receive them back. As a matter of fact, they may not revert to the settlor only on the death of the beneficiary, but it could also be a trust for a fixed term, on the expiry of which the settlor then receives his
money back.
Normally, there will be one lucky beneficiary for whom the settlor wishes to provide. It will all get rather complex if there is a class of beneficiaries, or successive interests, as that will tend to militate against the trust running its course as envisaged at the outset. Usually, the life tenant will be considerably older than the settlor. It could conceivably be the other way around, although in this case the beneficiary with the interest in possession will have to accept that his interest is likely to be terminated during his lifetime so as to allow the revertor to settlor.
It will be apparent therefore that these types of trusts can be useful, not only for tax planners, but also in a variety of situations where the general idea is to provide for someone for a period and then to recover the funds employed for that purpose.
The trust is not required to have an interest in possession at the outset. It could start out as a discretionary trust and convert to interest in possession at a later stage so as to allow the benefit of the tax reliefs discussed below, but there is not likely to be much point in this strategy now. It could give inheritance tax problems on setting up the trust, although there are methods by which this can be managed, but more importantly the usual idea of starting off in discretionary form is to allow a capital gains tax holdover relief into the trust. That advantage has now gone because there is no holdover into a settlor-interested trust. So, generally, the trust will have an interest in possession at the outset. Given this scenario, the tax provisions operate as set out below.
Inheritance tax
The transfer of funds into the trust will be a potentially exempt transfer, giving rise to no inheritance tax liability so long as the settlor survives for seven years. In any event, this is not your average common or garden potentially exempt transfer because of the reversionary interest retained by the settlor.
IHTA 1984, s 48(1)(B) provides that a reversionary interest retained by the settlor or his spouse is not excluded property and so remains part of his estate. For this reason the loss to the settlor's estate on making the trust is not the full amount of funds given to the settlement; it is that amount less the value of the settlor's reversion. If the settlor can benefit under a power of appointment which the trustees can exercise at any time, there may be little loss to his estate, but there may be ramifications as regards gifts with reservation, as mentioned below.
On the other hand, if the entitlement given to the settlor is delayed until a future date, the value of the reversion will undoubtedly be less than the full value of the funds transferred in.
If the interest in possession in the trust is terminated during the lifetime of the beneficiary, IHTA 1984, s 53(3) states that no liability is to arise under IHTA 1984, s 52 on that event. As will be seen in a moment, this is not by any means to say that that liability will not arise under a different provision.
If the interest in possession terminated on the death of the beneficiary, IHTA 1984, s 54(1) states that the value of the settled property is to be left out of account in determining the value of the deceased's estate immediately before his death. The settled property remains part of the life tenant's estate, but the value of it is left out of the account and no tax liability arises in respect of it.
The relief from liability applies equally if the funds revert to the spouse of the settlor or the surviving spouse of the settlor within two years of the settlor's death, so long as the spouse is domiciled in the UK.
Capital gains tax
This type of trust is, by definition, settlor interested and so, following FA 2004, s 116, there can be no capital gains tax holdover relief when it is made. The settlor will have to accept whatever the capital gains tax consequences are when setting up the trust. If cash is to go into the trust, there will be no problem, but if investments or property are to be transferred in, a capital gains tax position will arise. If losses arise, they will have restricted use as the settlor and the trustees are connected parties (see TCGA 1992, s 18(3)). In that event, some restructuring will be required to preserve the usefulness of the losses.
Any gains realised during the life of the trust will be assessed on the settlor, with right of recovery of the tax paid from the trustees. If this sounds like bad news, then get real, it is a cause for rejoicing these days! Trusts pay the top rate of capital gains tax whatever the circumstances, unless they are within the new vulnerable beneficiary provisions (and a settlor-interested trust cannot be within those provisions). So if the gains are assessed on the settlor, there is at least the possibility of tax being paid at a lower rate than 40%. It might even be nil if the settlor has losses to use up.
If the trust is terminated during the life of the beneficiary with interest in possession, there will be the usual notional disposal of the trust assets under TCGA 1992, s 71. The settlor will become absolutely entitled as against the trustees and so any gains to date will be brought into charge to tax. If the trust holds a property occupied by the life tenant, the gain may then be exempt under TCGA 1992, s 225.
If the trust terminates on the death of the life tenant, TCGA 1992, s 73(1)(b) provides that there is then to be a no gain/no loss disposal, in place of the normal tax-free uplift in the trust assets on the death of a life tenant.
A glance at paragraph 16121 of HMRC's Inheritance Tax Manual reveals that, for the inheritance tax exemption to apply, the settlor must be living when the property reverts, but it need not revert to him absolutely; the exemption applies if the settlor takes an interest in possession. This can be very useful in managing the capital gains tax position.
If the trust terminates during the lifetime of the beneficiary with the interest in possession, the funds do not have to go back to the settlor absolutely in order to secure the inheritance tax exemption; instead there could be continuing interest in possession trusts for the settlor. If that commences on the death of the original beneficiary with interest in possession, the capital gains tax position is even better. The tax-free uplift to market value in the capital gains base cost of the trust assets then operates in the normal way and so there are advantages for both inheritance tax and capital gains.
In setting up the continuing trusts, it would be essential to ensure that one does not stray into a bare trust for the settlor alone, as this is very easy to do if there is only one possible beneficiary remaining.
Income tax
Once again, by definition, the settlor is interested in the settlement and so very often would be taxed on any income arising by virtue of ITTOIA 2005, s 624. However, this will not always be the rule as there are a number of exceptions from liability under s 626. They are set out in ss 626 and 627, and in present circumstances, the most likely exception is a settlement made on divorce or separation. Some children's settlements also escape, but not generally in the present context.
Gifts with reservation
So much for the provisions which are fairly clear cut; now we enter tricky territory! If the settlor is interested in the trust, has he not made a gift with reservation for inheritance tax purposes? The answer may be yes or it may be no.
Before I hasten on to my next heading, you may welcome a little clearer guidance than that, but I am not sure that it can be given. In my earlier article, I robustly stated that there was no gift with reservation of benefit in the case of any revertor to settlor trust, and no-one challenged that statement at the time although it may have been slightly optimistic. What we do know from Ingram v CIR [1999] STC 37 is that FA 1986, s 102 'requires people to define precisely the interests which they are giving away and the interests, if any, which they are retaining. Once they have given away an interest, they may not receive back any benefits from this interest'. So it is perfectly permissible to give away a life interest in certain assets and retain the reversion; that carves out a particular interest for the life tenant and thus properly defines the interest given away.
However, it is highly desirable in any modern trust to give the trustees powers to terminate the trust or make appointments at any time, as the Government has become adept at performing unexpected tax u-turns. If the trust can be terminated the day after it is created, has one 'properly defined' the interest given away, or is it not the case that one has crossed the line somewhere and not really given anything of value away at all?
The answer is probably that the point has yet to be settled one way or the other, and there are views both for and against. In principle, one can say that the interest given away is still properly carved out so there is no reservation of benefit in it. An interest in possession is no less an interest in possession because it can be terminated during the beneficiary's lifetime. But if the settlor can benefit from capital appointments which can be made at any time, one instinctively feels that too much has been reserved out of the gift.
Pre-owned assets
The plot can get even murkier when it comes to Schedule 15 to the Finance Act 2004. We will not normally be worried about the provisions relating to land or chattels, but if the trust is to contain investments, at first sight there seems to be no reason why the pre-owned asset provisions relating to intangibles should not apply. As mentioned above, what used to be TA 1988, s 660A will normally apply to the income and the FA 2004, Sch 15 liability is linked to that. One will then be searching the exclusions and exemptions to see if they will help. If there is a gift with reservation, there will be no Sch 15 liability but, as we have just seen, that is rather a grey area.
What may be helpful are the provisions of Sch 15 paras 11(1) and (2) which contain an abatement from liability where the person's estate for inheritance tax purposes includes property which derives its value from the assets in the settlement.
That would seem good enough to describe a reversionary interest in the trust and in most cases this would deal with any Sch 15 problem, or at least reduce the taxable amount below the magic £5,000 figure. I have seen a note which indicates that HMRC consider that there is no pre-owned asset liability at all where the settlor only has a reversionary interest in a trust, but in my experience the Revenue has historically applied s 660A in these circumstances even where the reversion is quite remote. It may be that it has in recent years tempered its views in relation to s 660A and remote reversions, but I cannot believe that the tempering has stretched as far as letting a trust with the settlor named as a fixed beneficiary escape. The note says 'Revenue probably wrong here'! If the Revenue misinterprets the law, I wonder what chance any of us have.
What must definitely be avoided is the use of a general power of appointment retained by the settlor, instead of a reversionary interest. This will be a 'settlement power' and, following FA 2002, s 119, it is not an asset in the estate of the holder of the power.
Wider uses?
One might imagine that these trusts could be put to wider tax planning use.
Let us suppose that Ethel owns her own home and would like to do some estate planning with it, but does not want to move out.
Can she not give the home to her son, who then puts it back into revertor to settlor trust in which his mother Ethel is the life tenant? The trust can be structured to give the son the benefit of all of the tax exemptions, and in addition Ethel would have made a lifetime gift which she has to survive for seven years, but after that there is inheritance tax exemption on her death. What can be the snag with that?
The answer is that there are quite a few snags. If it is thought that one of them is under the pre-owned asset provisions, then at least that can be crossed off the list.
There are two good reasons why there is no charge under Sch 15.
The first is that by virtue of the trust, Ethel's home is back in her inheritance tax estate; she has an interest in possession in it and the fact that no charge arises on her death is neither here nor there. The property is still in her estate as life tenant.
The second reason is that Ethel has made a gift with reservation of benefit and the trust that was made by the son does not rub this out in any way. It still remains a gift with reservation and so for that reason also there is no Sch 15 charge.
The problems lie elsewhere.
First and foremost, who is the true settlor of the trust made by the son? If it is not the son, but Ethel, there will be no reverter to settlor exemption at all. By IHTA 1984, s 44, a settlor in relation to the settlement includes any person who has made it indirectly and any person who has provided the funds indirectly for the settlement, or made a reciprocal arrangement with another person to make the settlement. An arrangement by which Ethel agrees to give her property to her son, in return for which the son will make a settlement in her favour looks fairly reciprocal, even though one would usually think in terms of one asset being given, and a different asset being put back into trust if there is to be a reciprocal arrangement. One can expect HMRC to argue aggressively that Ethel is the settlor of the trust for inheritance tax purposes, unless there are some strong facts to counter this argument.
Ethel might also be the settlor for capital gains tax purposes. For some strange reason, FA 2004, Sch 21 para 2 widened the definition of 'arrangements' as regards identifying who the settlor is for capital gains tax purposes; the term now includes 'any understanding, whether or not legally enforceable'. This was rather an odd amendment as it does little more than set out what has long been understood from income tax cases such as Crossland v Hawkins 39 TC 493.
The second drawback is that the gift with reservation remains in place, notwithstanding the trust in Ethel's favour made by the son.
This will not be any worry on the death of Ethel because there could only be a gift with reservation charge on that occasion if the relevant property does not form part of Ethel's estate immediately before her death (see FA 1986, s 102(3)). Immediately before her death, the property is in fact in her estate by virtue of her life interest although, as we have seen, there is a special provision which prevents a tax liability on the value of it on her death.
The snag arises if Ethel wants to move out of the property during her lifetime. If the property is then sold and the trust wound up, the reservation of benefit will end in Ethel's lifetime. There is no tax charge under IHTA 1984, s 52, but there is nothing to prevent a deemed potentially exempt transfer at that time under FA 1986, s 102(4). That transfer could well become a chargeable transfer given Ethel's age. So one would need to be careful to keep the trust for her benefit in existence until her death, even if its original purpose has ceased to be of
any interest.
Tax planning
What we glean from all this is that reverter to settlor trusts are not all that suitable for the tax avoidance industry, notwithstanding the good fortune of the tax avoiders in Fitzwilliam v CIR [1994] STC 502 who succeeded with such a trust in the House of Lords. They can, however, be of great use in unravelling other estate planning structures which have become out of date. Given all their many uses, I hope their tax privileges outlive iPods and Bluetooth.
Malcolm Gunn is a tax consultant with Haarmann Hemmelrath where he provides a consultancy service to other professional firms. He can be contacted by telephone on 020 7382 4862 or by e-mail at Malcolm.Gunn@haarmannhemmelrath.com.
