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Our client is a trustee of a life policy settled in trust nearly 20 years ago and which has remained unchanged throughout.
It is an ‘interest in possession trust’ and at the outset the settlor gave his then wife a life interest in the policy proceeds.
After the death of his first wife (which occurred in October 2010) the interest in possession passed to a lady friend who by that time had become his wife in May 2006, several years after he had divorced his first wife.
The value of the life policy in trust is only around £60,000 and no returns have been made to HMRC because no taxable events have arisen.
It has only just come to my notice that perhaps the trustees should have notified HMRC of the termination of the first life interest and that some inheritance tax may have arisen as a result.
Unfortunately, the estate of the deceased first wife has been wound up and distributed and a relatively small amount of inheritance tax has been paid upon it.
Can readers offer guidance, please, on what action the trustees should be advised to take immediately and what the likely consequences will be of doing so?
Query 17,976 – Taken Aback
Reply from Hillview
Although one would want to review the manner in which the second wife’s income entitlement arises, it does seem to be the case that both the first and second wives’ income entitlements are qualifying interests in possession for inheritance tax purposes, the second wife’s entitlement being a ‘transitional serial interest’ under IHTA 1984, s 49E.
The changes made in the taxation of trusts in 2006 resulted in most new lifetime settlements made after 22 March 2006 falling within the inheritance tax relevant property regime with its scheme of periodic and exit charges (the simplification of which is due to be the subject of government consultation), and which effectively treats a settlement as taxable as a discrete entity for inheritance tax purposes.
However, transitional relief was provided in the case of pre-existing interest in possession trusts, in terms of ‘qualifying’ a succeeding interest in possession to that in existence at 22 March 2006, but in most cases that relief came to an end on 5 October 2008; exceptionally, however, an extended transitional period is provided for in s 49E in respect of pre-March 2006 policies held in trust
Such qualifying interests in possession preserve the statutory fiction (s 49) by which the life tenant is deemed to own the underlying capital supporting the life interest for inheritance tax purposes so that on termination of the interest in possession it is the life tenant who is regarded as making the resulting transfer of value.
Thus, on the death of the first wife, who held a pre-March 2006 interest in possession, which was therefore also a qualifying interest in possession, the settled capital is treated as part of the estate of the first wife at the time of her death and is accordingly aggregated with her free estate to ascertain the applicable rate of inheritance tax; each of the free estate and the settled fund then bears tax at that estate rate.
The first wife’s personal representatives are liable for inheritance tax on the free estate and the trustees on the settled property.
The personal representatives must deliver an account of both the free estate and the settled property; on delivery of the account they must pay the tax on the free estate and they may pay the tax on the settled property if the trustees so request them, in which case they have a right of reimbursement from the trustees (IHTA 1984, s 226(2)).
However, even if the personal representatives have already delivered an account of the settled property, the trustees must deliver an account before the expiry of 12 months from the end of the month in which the deceased life tenant died, and have the primary liability for any tax attributable to the settled fund.
Therefore, the trustees in this case will need to provide the first wife’s personal representatives with full details of the aggregable trust fund to enable them to file a corrective account in the free estate when assessments will be issued identifying the additional tax and the apportionment of that liability between the free estate and the trust fund.
Likewise the trustees should file their own account (IHT100) immediately; as it will be out of time, penalties for both late filing and a tax-geared penalty for late paid tax could be levied, although it may be possible for the trustees to mitigate the full penalties by offering a ‘reasonable excuse’ for the delays that have occurred.
Of course, the additional tax liability will be calculated on the value of the aggregable trust fund at the date of the first wife’s death, and this raises the question of the value to be placed on the extant life policy.
HMRC’s Inheritance Tax Manual at IHTM20221 et seq reviews the applicable principles, but in general terms the open market value to be placed on the policy in October 2010 will be the amount for which the policy could be sold, and not necessarily its surrender value, and subject also to a separate general rule that the open market value cannot be less that the premiums paid. In the circumstances it might be worth verifying the policy’s value in October 2010.
Reply from Terry ‘Lacuna’ Jordan, BKL Tax
The terms of the trust over the life policy were apparently such that the interest of the settlor’s first wife subsisted past their divorce and, on the first wife’s death in October 2010, the interest in possession passed to the settlor’s new wife.
The original interest in possession, which arose before 22 March 2006, was an ‘estate’ interest such that the value of the policy formed part of the first wife’s estate for inheritance tax purposes.
When the first wife died in October 2010, a charge to inheritance tax arose by virtue of IHTA 1984, s 52. Had the settlor’s new wife become absolutely entitled on that occasion, no charge would have arisen by virtue of s 54(2)(a).
The trustee is liable for the inheritance tax (which will be based on the actuarial value of the policy as at the date of death aggregated with the free estate and any other chargeable property) under IHTA 1984, s 200(1)(b) and is obliged to deliver an account to HMRC under IHTA 1984, s 216(1)(b).
The personal representatives should consider whether they need to remedy their defective account under IHTA 1984, s 217.
The interest taken by the new wife is apparently a transitional serial interest by virtue of IHTA 1984, s 49E.
This could actually prove disadvantageous since the value will form part of the second wife’s inheritance tax estate.
Had the value passed into the relevant property regime it might well have been below the nil-rate band for ten-year and proportionate or ‘exit’ tax purposes.
