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THE FINANCE BILL changes in the inheritance tax treatment of settlements will be considered in Committee on 13 June. The current provisions to 'align' will trusts create major problems in relatively straightforward family wills (and even for the intestate estate). As this article will show:
(i) existing flexible wills no longer have the benefit of the spouse exemption and, despite assurances to the contrary, the position cannot be rectified after death;
(ii) a new will settling residue on a life interest trust for the surviving spouse with the usual power to apply capital will not attract the spouse exemption; and
(iii) the hitherto standard practice of combining a nil-rate band trust with a life interest trust of residue for the surviving spouse will result in tax charges on the nil-rate band trust being calculated by reference to the value of the residuary 'estate'.
Many existing family wills have been drafted to give the surviving spouse a life interest in residue, often with flexible overriding powers of appointment. There are a number of reasons why this is a relatively standard procedure, notably when the testator has been married more than once and has children from earlier marriages. All such wills have been drafted on the basis that the spouse exemption will be available on the testator's death. However, as a result of the Budget proposals currently in Finance (No 2) Bill 2006, it appears that such a trust will not satisfy the requirements for an immediate post-death interest (IPDI) and so spouse relief will not be available in the event of the testator dying without having altered his will.
Solving the problem by s 144
It has been suggested that the position could be saved by the trustees exercising their overriding powers (which we will assume are sufficiently widely drafted) in order to appoint the more restricted interest in possession (IIP) trust that will qualify for the spouse exemption as an IPDI. In general terms, any appointment made within two years of death is said to be 'read back' into the deceased's will. However, the reading back is dependent on the conditions laid down in IHTA 1984, s 144 being met.
One of these is that the appointment made by the trustees must be 'an event on which tax would (apart from this section) be chargeable'. The meaning of this provision was considered by the Court of Appeal in Frankland v CIR [1997] STC 1450. In the High Court, counsel for the Inland Revenue (see [1996] STC 741 at para 9) was unable to explain why this requirement had been included in the section — it is simply a trap for the unwary! And in the case of our flexible will, it will likewise prevent reading back given that — since the 22 March changes — an appointment by the trustees of a relevant property settlement onto interest in possession trusts will not be an event which is chargeable. In order for the interest in possession to be a chargeable event, it needs to qualify as an IPDI and this is not possible because it fails condition 1 of the requirements for an IPDI; i.e. that it is effected by will. The interest in possession is effected by the appointment, and the deeming provision in s 144(2) to obtain reading back cannot operate until the chargeable event arises in the first place. The draftsman (Sch 20 para 27) has inserted new s 144(1A), but this does not enable one to treat an interest in possession arising by appointment as an IPDI. As a result, all that can be done by s 144 if spouse exemption is desired is to appoint the property to the spouse outright and that may be precisely what the testator wished to avoid.
What is necessary?
The current provisions of Finance (No 2) Bill penalise taxpayers who die without having had a chance to alter their wills. Ensuring that s 144 can be used to rectify the position should help — if not in all, then certainly in many cases, where trustees have sufficient powers to create an IPDI. Perhaps the simplest way of revising s 144 would be to provide that if any appointment by the trustees occurs within two years of the testator's death, then the trustees will be able to elect that the deceased's will be varied for all purposes so that it is to be treated as providing for the property to be dealt with as it is after the event.
The problems of new s 49A
The proposed new IHTA 1984, s 49A (introduced by Finance (No 2) Bill 2006, Sch 20 para 5) sets out six conditions before a trust can qualify as an immediate post-death interest (IPDI). We will touch on each of these in turn, but conditions 3 and 4 are the most problematic. What are the tax advantages in qualifying as an IPDI? This can best be illustrated by way of the Example below.
| Example |
| A dies with no available nil-rate band and leaves his property worth £500,000 on trust for his spouse ('L' in the legislation) and then to his children at 35. His spouse L dies 15 years later. The trust does not qualify as an IPDI so that the spouse's estate is not increased in value and no spouse exemption is available. Hence inheritance tax is paid on A's death of £200,000. During the course of the next 15 years while L is alive, there is a ten-year charge (currently a maximum of 6%) on the value of the settled property plus an exit charge on any distributions of capital to L or the children. On L's death there is no inheritance tax payable because the trusts do not end until the testator's children are 35. The relevant property regime (with its ten-year and exit charges) continues. The property is not treated as part of L's estate (because she does not have a qualifying interest in possession) so the tax charge on the death of the life tenant does not apply. |
In the Example, the failure to satisfy the IPDI conditions means that the tax charge of 40% is accelerated: it is not paid on the second death, but on the first spouse's death and there is some additional inheritance tax to pay during the course of the trust's existence and on capital distributions, albeit at relatively low rates.
Contrast this with the position if A had died and left his residuary estate on a trust that did qualify as an IPDI. Then the effect is that no inheritance tax is payable on the death of A because of spouse exemption: L's estate is increased in value (see new s 49(1A)) since she is treated as beneficially entitled to the underlying capital and therefore IHTA 1984, s 18 applies. There is no 6% charge during the trust's existence nor on payments of capital, but on the other hand if L fails to survive seven years from the inter vivos termination of her interest, there is up to 40% tax payable then. On L's death the remaining settled capital may also be taxed at 40%.
Most married couples will want to defer the inheritance tax charge until the last death, not least because their most valuable asset is generally the matrimonial home and they will not want it sold to pay inheritance tax on the first spouse's death. If the house was in the sole name of the deceased, the inheritance tax problem could be exacerbated. (This is not an uncommon situation if the deceased has married a younger spouse who has moved into the deceased's existing home.)
Satisfying new s 49A
What then, are the requirements for a trust to satisfy the six conditions of new s 49A and therefore qualify as an IPDI?
The first condition is that the settlement must be effected by will or under the law relating to intestacy (or by a 'read back' variation under IHTA 1984, s 142). This presumably rules out adding property to existing settlements set up before death. The third and fourth conditions are the most controversial. Their effects are best illustrated as set out below.
Condition 3 provides that if L's interest can be brought to an end by the exercise of a power, then new s 49B must apply in relation to that power. New s 49B states that if capital is advanced to someone other than L, then L must consent to this and if L's interest is terminated for any other reason then the power to do this must be exercised by L whether alone or jointly (not merely that she must consent to it). One might well question why the Government is seeking to impose such conditions in return for giving the spouse exemption. Many testators would want to ensure that if a surviving spouse remarries, his or her interest should be terminated at that point whether or not he or she consents to this. The existence of such a power to terminate L's interest without L's (the surviving spouse's) consent will now mean the loss of spouse exemption. Why is the Government concerned to restrict testator's wishes in this way?
Moreover a mere power to advance capital to the spouse L could result in condition 3 being breached.
Take a typical will as follows.
'I leave my residuary estate on trust:
(a) for my wife for life and my trustees shall have power to pay or apply capital for her benefit;
(b) subject thereto for my children in equal shares absolutely.'
Under the will, the usual statutory power of advancement applies and all the children are adult.
On the basis of the Budget press release, BN25, it might be assumed that this wording creates an IPDI so that the spouse exemption will be available on the testator's death. In fact it appears that this wording fails both conditions 3 and 4 so that the residuary estate is taxed on the testator's death.
The existence of the power to apply capital for the wife's benefit causes a problem because condition 3 is not satisfied. The power can be used to bring the wife's interest in possession to an end (by, for instance, transferring the capital of the trust fund to her): hence new s 49B must apply in relation to the power. Accordingly, the key question is whether (i) the power is exercisable by the wife (it is not — it is exercisable by the trustees) or (ii) whether each non-beneficial exercise requires the wife's prior consent. Looking at new s 49B(3)(b), it is clear that the exercise of the power would not be a non beneficial exercise (so the question of consent is irrelevant).
It might be said that if the wife was a trustee, the problem would not arise because then the requirement in s 49B(2)(b) would be met. This seems unlikely, however, given that what is envisaged appears to be a power which is personal rather than one given to a fiduciary body. In any event it would be odd if the trust was an IPDI only for as long as the wife was a trustee. She might lose capacity and be removed as a trustee. In that event are we to say that the trust loses its status as an IPDI trust?
Alternatively, it might be argued that the exercise of the power would not terminate the wife's interest in possession. After all, she is for instance being given the capital and hence remains entitled to the income so there her interest may be said to continue. This argument will not, however, wash since the position is expressly dealt with in s 49B(b) — which would not be necessary unless condition 3 had to be met — and also in new s 49A(5)(a) which is drafted on the assumption that the absolute entitlement of the wife involves the termination of the IIP.
Presumably, a simple solution would be to amend the wording of the Finance Bill so that condition 3 can be met if the power can only be exercised in accordance with one of the ways identified in s 49B(3)(b) (i.e. L receives the capital) or alternatively to say that condition 3 does not have to be met at all if the termination of the interest in possession results in L becoming absolutely entitled. The present difficulty is that L becoming absolutely entitled is an event that still needs to meet the conditions in s 49B and s 49B simply does not cater for L's absolute entitlement.
Condition 4
On one interpretation of the legislation, condition 4 is also a problem. Condition 4 requires that on L's interest ending (whether during L's lifetime or on her death) the trusts will end and a person 'will become absolutely entitled to the property'. (There are limited exceptions for bereaved minors or disabled beneficiaries or if the default trusts are in favour of charities.) What does 'will become absolutely entitled' mean in this context?
In the above example, the terms of the will provide that the children become absolutely entitled on L's death. However, the statutory power of advancement is available which means that the trustees could make a settled advance to defer the children's absolute entitlement in a moiety of their entitlement. Does the very existence of this power mean that condition 4 is not met at the date of L's death or should one apply a 'wait and see' policy: i.e. say that the trust is an IPDI until such time as the trustees exercise the settled power of advancement and defer the children's entitlement to capital? Condition 6 (which states that conditions 3 to 5 must have been satisfied at all times since L became beneficially entitled to the interest in possession) would suggest that this wait and see interpretation is tenable.
However, if that is wrong it would mean that a trust arising when someone died intestate leaving adult children and a widow would not qualify for spouse exemption. The presence of the statutory power of advancement means that since the children's absolute entitlement on the death of the widow is capable of deferral there is no spouse exemption because one cannot say for certain that the children 'will' become entitled. (Curiously, and unlike trusts for bereaved minors in IHTA 1984, s 71A, new s 49A does not expressly deal with the statutory power of advancement.)
Also curiously, there is no provision anywhere in the legislation that provides for a clawback of spousal relief in the event that the conditions in new s 49A are subsequently breached. It would thus seem that on any breach, the IPDI is replaced by a relevant property settlement with the life tenant treated as making an immediately chargeable transfer.
S 80 and relevant property settlements
It is common will drafting for a testator to:
(i) establish a nil-rate band discretionary trust (NRBDT); and
(ii) to settle the residue on IIP trusts for his spouse.
Before 22 March 2006, the effect was that by virtue of IHTA 1984, s 80 the trust of residue was not treated as arising until the termination of the spouse's IIP. This
meant that the two settlements were not related within IHTA 1984, s 62.
A proposed amendment in Finance (No 2) Bill will, however, disapply s 80 in cases where the spousal IIP arises on or after 22 March 2006 (see Sch 20 Part 3 para 23). Whilst this amendment is understandable in the case of:
(i) life interest trusts; and
(ii) IIP trusts set up by will which do not come within the new s 49A;
it will create difficulties in the case of wills which set up an IPDI interest for the surviving spouse. IHTA 1984, s 83 has not been amended so that the two trusts will be created on the same day and will therefore be related settlements within IHTA 1984, s 62. The value of the property in the IPDI will therefore be taken into account in fixing the rate of tax that applies to the nil-rate band discretionary trust.
Capital gains tax problems
Quite separate from the problems arising on death, it is worth remembering that someone can pay both capital gains tax and inheritance tax if he or she transfers assets inter vivos to a trust after 5 April 2006.
Suppose on 17 July 2006 A settles property into a trust for his children who are all adult. He claims holdover relief on the basis that the gift into the trust is a chargeable transfer (TCGA 1992, s 260). He pays inheritance tax of, say, £20,000.
Four years later, A has a baby. A minor child can now benefit from the trust and hence A has to pay capital gains tax on the gain because it has become settlor interested. He cannot set off his inheritance tax liability against his capital gains tax bill. Moreover, he pays capital gains tax on the untapered gain. There is some limited relief in s 260(7) where the trustees later dispose of the asset, but this will not help A.
Surely as a minimum A should be allowed to set off the capital gains tax liability against the inheritance tax liability and the clawed back gain charged to tax should be the gain after (not before) taper? BN25 suggested that one could claim holdover relief in these circumstances, but in fact the Finance Bill makes no provision for this.
Conclusions
The changes announced in BN25 are wide ranging and, by no stretch of the imagination, limited to the very wealthy. It is likely that some of the problems outlined in this article are the inadvertent result of major tax changes being introduced without adequate consultation and the production of draft clauses. However, by providing for the changes to take effect from 22 March the Government has made it virtually impossible — until the present uncertainties are resolved — to draft any will other than in the most straightforward terms with absolute gifts to the surviving spouse. Whatever happened to the principle that tax legislation should be certain so that every citizen is entitled to run his life without arbitrary interference from the executive?
Chris Whitehouse and Emma Chamberlain are barristers at 5 Stone Buildings, Lincoln's Inn, WC2A 3XT; telephone: 020 7242 6201; or visit their website: www.5-stonebuildings.law.co.uk.
